Chart Chat - Gaps

The best indicator of where price is likely to go (near-term) is the price chart itself. However, there are hundreds of indicators created to help solve this problem. Yet, all we have to work with on charts is:
- Price (Open, High, Low, Close)
- Volume
- Time
All indicators are derived from these three factors and their many combinations. The goal is to see into the future, to determine where the price will go! Forget it… We can never know with certainty where the price will go. We can improve the odds, increase the likelihood of our “guess-success,” and that can provide the “edge” needed for success in the market. Proper use of indicators can be very rewarding.
The price chart can send subtle messages and indicators can help understand those messages. But, of paramount importance:
Most price charts tell us nothing most of the time!
Studying charts for last weeks picks I was struck by the abundance of gaps occurring in price patterns. Let’s consider gaps in price patterns and what they mean to us as traders. For example, look at the following price pattern on CPKI on 4/23/04.

Fig. 1. Gaps on price chart.
In this short five month period there are no fewer than five gaps as shown by the arrows. If you look carefully you may find more. The following chart is a repeat of the last in Candlestick format.

Fig. 2. Previous price chart (CPKI) in candlestick format.
Same information, different focal angle. I prefer the candlestick, where the price-bar body provides substance, with the tails (shadows) more for color. The most common market maxim we hear about gaps is that they are always filled. Look at Fig. 2 above in that regard. The first gap in early January was indeed filled in mid-March. The same can be said about the next three gaps, each being filled by subsequent price action. What about the last gap, on April 23rd? Move the time ahead to see what happened:

Fig. 3. Previous price chart (CPKI) extended in time to show closure on the last price gap.
See how the lower shadow, two days later, magically dropped to fill the gap (on a very high volume down-day)! John Bollinger, of Bollinger-Bands fame, suggests gaps are generally caused by new information entering the market while it is closed. He regards gaps as important to the price structure, containing significant information. Let’s examine gaps and try to find their significance.
First, lets distinguish gaps that matter from those that don’t (between significant and insignificant gaps). Meaningless gaps include:
1. Those equal to the normal interval between successive bids. That is, most stocks trade at intervals of an eighth of a point. If a stock closed at its high for the day at $12 per share, then opened the next day one eighth higher, such a gap has no significance. Higher priced stocks trade at higher spreads, ¼ or ½ point. Gaps at this level have no technical significance.
2. Insignificant gaps often occur in medium to high-priced stocks with low trading volume.
3. Ex-dividend gaps occur often when a company pays a dividend. These also have no technical significance.
Significant gaps regularly occur in four styles on price charts.
1. Common – the least important of the four, this gap normally occurs in thinly traded markets or when price becomes congested. Often, it is simply the result of poor trading interest. The gaps in CPKI shown above fall into this category, where the price action is in a trading range. This is a form of congestion, when viewed from a larger perspective. Look at the weekly chart for the same ticker.
Fig. 4. Weekly view of CPKI, showing the relative congestion.
Common gaps regularly occur with low trading volumes, due to the congestion. These gaps have little forecasting significance. However, they can provide a clue the price pattern is in a congestion pattern. For example, look at the common gaps in the following price patterns.

Fig. 5. Common gaps in trading pattern.

Fig. 6. More “Common” gaps in trading pattern.
The other three significant gaps are Breakaway, Runaway (or Measuring), and Exhaustion gaps. We will cover each with several chart examples in subsequent chats. For now, let’s close with the following observation. We began this chat with the market maxim, “gaps are always filled.” Although many gaps are filled within a short period of time, that is not magic, it is just simple probability. Since most charts trade within certain price ranges, the odds are pretty high that eventually the gap will be filled. In Figure 3 above, the down-gap in early January was filled in mid-March. That’s over two months later. Gap-fills beyond a few days to a week apart lose significance to traders. But the point, there is no law nor logical reason why a gap must be filled (or closed). Basing an investment decision on “gaps always fill” is not good trading. We will discuss when it is wise to consider gaps in trading strategies later.
Be Diligent
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