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| Articles and Tutorials |
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| "GAPS, GAPS and MORE GAPS" |
| by Ryan Litchfield |
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There is general knowledge of gaps but most people do not know enough about the many
types of gaps and their respective importance. The understanding of gaps begins with
the gap theory. But while the gap theory deserves a thorough discussion, I want to focus
on the types and relative importance of the many different gaps and leave a detailed
treatise on the Gap Theory to another time. Nonetheless, a quick lesson on the theory
is warranted to set the stage. First off the definition of a gap is when the closing
price and the following opening price is different. There are true gaps and body gaps
just to name a few but a quick run through of the gap theory will serve to set the stage.
THE GAP THEORY
The gap theory simply states that there is a pattern to gaps. Gaps usually come in
groups of 3-4. Typically a gap will happen in conjunction with a change of direction
or at a break out above a support or resistance. The gap is followed by a run in the
direction of the gap. The absence of news enhances the importance of the gap because
there is always some news associated with a gap and if it is not common knowledge at
the time, the news is privy to some influential folks ands will eventually hit the
street at which time the public gets it's chance to respond which is often the occurrence
of the next gap. Number two gap is a continuation gap and often there is a second
continuation gap. The final gap is referred to as an exhaustion gap and it is generally
near a support or resistance area. The idea of a final gap implies that the directional
move / trend is running out of steam and a reversal is eminent.
FILL RATE
The strength and importance of a gap is generally judged by how quickly it is filled.
Because opening gaps happen so frequently, a gap that fills the next day or in a few
days is not much more important than one that fills in a few hours.
BODY GAPS
A Body Gap happens when the bodies (the space between the open and close) of two consecutive
days have no common price activity. The high and the low however overlap so that at the
end of the day there is no un-traded area.
TRUE GAPS
A True Gap leaves an area of un-traded prices so that you can draw a horizontal line between
two days and not contact anything.
CLEAN GAP / DIRTY GAP / BREAK AWAY GAP
A Clean Gap is one that does not have any recent overlap. Recent is a relative term but
typically, if there is a trend in place a clean gap will not gap part of the existing trend,
rather it will extend the trend.
A Dirty Gap is a gap over recently traded prices. Often a gap happens at the resumption of
a trend. The trend will retrace a bit and then re-ignite. This is a dirty gap and while the
gap is important and the trend is reaffirmed, the gapping of recently traded prices is not as
significant as the clean gap.
A Break Away Gap is a clean gap and a true gap that extends the trend into new territory.
It breaks out of the confines of a trading range.
ISLAND REVERSAL (Cluster Gap)
Well we saved the best for last. The Island or Cluster Gap may be the most significant gap.
It is most important at a major support or resistance level. The market sees the stock at a
major bargain or very over bought. One more newsy gap in the direction gets very little follow
through. The stock remains at the support of resistance level. Anxious to either catch the
next rally or cash in at the first sign of trouble, another news item or rumor can spark a mad
rush in a new direction. This signal is a strong one and it is rare enough that it is recognized
as such and those who act on it often get great entry points on major trend reversals.
SUMMARY
Most stocks and indexes gap regularly but they are body gaps and fill during the day. While all
gaps have significance, that significance can vary widely. The gaps of a stock that gaps
frequently (even true gaps) are generally discounted and or ignored altogether. The hierarchy
of gaps rides on the area that is gapped as well as how quickly it fills. A breakaway gap with
no news, happening at a major pivot point like a 52 week high / low or an all time high / low
would have to be considered a '10'. A reversal gap at the same locations would be a close second.
Add the island or cluster characteristic to the reversal and you get a '10+'. Gaps tell you a lot
about the sentiment of the traders and knowing how to interpret and weight them can only help you
in your trading.
Now you have a good handle on gaps but a whole other subject is where gaps open and close and why.
But that is another subject for another day.
-- Ryan
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