Trading Price Gaps - Part Two

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by John Jagerson


Breakaway gaps are useful indicators for a resumption of a trend following a consolidation pattern or an emerging new trend. These gaps happen when investor sentiment shifts strongly and usually represent a much larger than average price move. Because these shifts are so large they are usually accompanied by very large volume.Gaps
 
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To see the first article in this series, click here.
To see the third article in this series, click here.

In the last article I illustrated a breakaway gap occurring on Apple, Inc. (AAPL) that followed a short pennant formation. That is a very typical scenario for this kind of gap pattern to occur. You can see a second example of a breakaway gap in a similar situation in the chart below.

Apollo Group, Inc. (APOL) channeled between $50 and $60 a share for most of October. That channel was interrupted on 10/29 when the company filed its annual report with the SEC. The new information within the report was obviously good news for investors who moved into the stock forcing it to open above the previous high on strong volume.

APOL

A gap like this is clearly a bullish signal but it also establishes an inflection point on the chart that is likely to act as support in the future. It is common for a stock to continue higher following a breakaway gap and then return to the top of the gap and bounce higher again. You can see this on the chart above with a bounce in late November.

When this happens to the downside traders refer to it as a "dead cat bounce." You can see an example of a bearish breakaway gap with a subsequent resistance bounce in the chart below. Shorting a stock at the initial gap or at the bounce is a strategy popular among shorter term traders.

Gaps

As you can see in the chart of Exxon Mobil (XOM) the break away gap on 6/22 occurred on high volume and ultimately lead to 4 moderate resistance (dead cat) bounces. A breakaway gap will frequently turn into a fairly solid support or resistance level and those levels should be monitored as the market approaches them.

Sometimes breakaway gaps will occur in a series of two opposing breakouts. These are often called island-reversals. An island reversal is a very important signal that sentiment in the market is overextended and a change in trend is coming. For example, a bearish island reversal would consist of a bullish breakaway gap followed by a short consolidation and then a bearish breakaway gap. You can see an example of this formation in the chart below.

Gaps

The breakaway gap that occurred in April on Google (GOOG) looked good but ultimately it only led to a downward sloping channel. Smart technicians could have turned this failed long position into a profitable short trade once the bearish breakaway gap in July turned this pattern into an island reversal.

A breakaway gap is most relevant when it occurs on a breakout from a consolidation or channel on higher than average volume and a larger than average price move. The conditions of a breakaway gap are not always as idealized as the examples shown in this article so take some time to practice identifying them on your own.

Next: How to Profit from Falling or Rising Home Prices
 
Gaps

Comments Add New
Teddy   |2009-09-16 00:31:06
Hi John,

What about the strategy where traders target the gaps saying that
all gaps must be closed?

Thanks
John Jagerson  - Closed gaps   |2009-09-16 02:23:22
Teddy - Most technicians will wait for confirmation of a bounce from support or
resistance before taking a trade anyway.

Also not all gaps are filled.
According to Bulkowski's studies it takes on average 3 months for a breakaway
gap that will be filled to be closed. That leaves plenty of risk/opportunity to
manage.

Anecdotally speaking, that matches my experience as well. Normal
market volatility will fill many gaps in the long term but the short term risk
of a support or resistance bounce at the gaps border should be handled.
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