Chart Chat - Gaps-3

1. 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

2. 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.

3. 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!

4. In our last chat, we covered both Breakaway and Runaway gaps. The following price chart shows two breakaway gaps, one at the start of the move in February, the other at the end in April. The first gap was not filled until over three months later, the second in a few days. Breakaway gaps on large volume do not need to be filled, or are usually not filled in the near-term.
   
   Fig. 1. Breakaway gaps on LIN price chart.

5. The next chart shows the same ticker, LIN, but with weekly price bars. Notice during the same time frame, first quarter 2004, the gap is hidden. That is why gaps on weekly charts are more rare (and more significant).
   
   Fig. 2. Weekly chart on LIN, hiding the gaps.

6. The last gap in our discussion is the “Exhaustion,” or “Climax” gap. This occurs when the price gaps to a new extreme but fails to follow through. It is the last gasp of an up or down move. After the gap, the price then falls back and closes in the opposite direction. For example, the next chart (RIO) shows an exhaustion gap in early January signifying a reversal of the uptrend. This type of gap occurs after an extended price move and is usually followed by a reversal in the trend.
   
   Fig. 3. An exhaustion gap in early January on RIO.

7. The next chart (NKTR) illustrates an important feature of some exhaustion gaps. We see how price moved up handily the first half of January. Then it struggled in a trading range until the “gasp,” a very high volume try for an increase, that lasted only a few bars. In this case, it then gapped down for subsequent price action. When this occurs, it is called an “island reversal,”
   
   Fig. 4. An exhaustion gap, resulting in an “Island Reversal.”

8. This unique example of the exhaustion gap is an “island reversal,” when prices gap higher after an extended advance, trade one or more days leaving the gap open, and then gaps lower. This leaves an island at the top, which may consist of a single day, or several days before gapping down. Island reversals often signal major trend reversals and should be given significant weight unless the gap is eventually filled. In this example, the gap was filled a few weeks later, decreasing its significance.

9. The next chart (SUNW) shows the struggle going on between the bulls and bears with two (or three) exhaustion gaps keeping the price from going higher.
   
   Fig. 5. Exhaustion gaps maintaining the down-trend.

10. In this next chart, we see a great example of an island reversal, which is in fact a combination of an exhaustion gap in one direction and a breakaway gap in the other. This can occur within a few days or longer as in Fig. 6. The island reversal is a significant event, usually signaling a trend reversal.
    
    Fig. 6. Island reversal (exhaustion gap plus breakaway gap) signaling a reversal in trend.

11. Okay, what goes on behind the curtain with exhaustion gaps? Remember this; all price movement in all markets is the action/reaction between forces of supply and demand. With an exhaustion gap-up, prices move rapidly until, suddenly, they meet an abundance of supply. At that point, the move ends abruptly with a high trading volume day. The gap is usually accompanied by a day of relatively high volume.

12. Exhaustion gaps do not occur often, coming at the end of up or down trends. After an exhaustion gap, a pattern will usually form that eventually leads to price continuation or reversal. If price does eventually continue in the direction it was moving, we can expect at least a time delay in the price advance. The delay allows us to consider our position carefully, to wait until we have more evidence before taking action. The next chart shows such an example.
    
    Fig. 7. A more typical exhaustion gap, closing quickly.

13. How do we trade an exhaustion gap? While this gap sounds useful as a technical signal, we realize the difference between an exhaustion gap and a runaway gap is one of hindsight. However, an exhaustion gap can often be recognized early in the trend reversal. Either way, when one of these gaps occur, a protective stop near the top of the gap will get us out if it reverses as in Fig. 7. Check that out for all gaps shown in charts above.

14. There is one more gap type we need to consider, as shown in the next chart. This gap was driven by a news item, as shown in Fig. 9. The importance here is there are occasions where gaps (radical price moves) will occur without warning. News may be anticipated, however that usually requires inside information, something we shouldn’t have.
    
    Fig. 8. A breakaway gap with no apparent technical reason.
    
    Fig. 9. News event, 4/13/04, causing price jump.

15. Gaps form on normal chart patterns among all stocks we consider. Clues are provided in many cases, other times we study the result in hindsight. If no other message is sent in this chat, one fundamental fact remains, ALWAYS USE STOPS!