Technical Analysis I

Theory of Price Gaps

What is a ‘Gap’ in technical analysis?

A gap is an area on a price chart in which there were no trades. It is easy to see gaps if you take candle stick charts. Let us try to understand gaps in another way. The fluctuations in stock prices are coherent in nature. That means that the price rises or falls gradually.  Thus, in rising scrip, if on one day the low was Rs 100 and the high was Rs 135, on the next day the low would be Rs 130 and the high Rs 140. Here, the low for the next day falls within the high-low range of the previous day. But suppose for the second day, the low was Rs 145 and the high Rs 150. Then, the low for the next day has fallen above the previous day High-Low range, or it was higher than the previous day’s high. So, when one draws bar charts showing High-Lows every day, there would be a discontinuity, termed as a ‘Gap’ in technical theory. An interesting feature of Price gaps is that it gets filled within a short amount of time. That is, the price would come back to fill the price gap of Rs 140 – Rs145, where there was no trade in the previous days.

In simple terms-a gap occurs when the current bar opens above the high or below the low of the previous bar. On a price chart, a space appears between the bars indicating the gap.

Types of price gaps

Gaps can be subdivided into four basic categories:

  • Common Gaps
  • Breakaway Gaps
  • Runaway Gaps and
  • Exhaustion Gaps.

Common gaps:

Common gaps are ‘common’ and ‘uneventful’. If a Gap is formed when the markets are moving in a narrow range, it is called a Common Gap.

Breakaway Gaps:

A “breakaway” gap ends a consolidation pattern and happens as prices break out. Often, they would be accompanied by huge volumes. Break-out Gaps are generally not filled for a long time, i.e. in the case of an uptrend, the price does not fall back to wipe off the gains. They may be filled as and when the prices retrace after a substantial up move. If the breakout happens to be a downtrend, the prices may not rise soon to wipe off the loss.

Runaway Gaps:

Runaway gaps are best described as gaps that are caused by increased interest in the stock. For runaway gaps to the upside, it usually represents traders who did not get in during the initial move of the up trend and while waiting for a retracement in price, decided it was not going to happen. Increased buying interest happens all of a sudden, and the price gaps above the previous day’s close. This type of runaway gap represents an almost panic state in traders. Also, a good uptrend can have runaway gaps caused by significant news events that cause new interest in the stock. Runaway gaps can also happen in downtrends. This usually represents increased liquidation of that stock by traders and buyers who are standing on the sidelines. These can become very serious as those who are holding onto the stock will eventually panic and sell – but sell to whom? The price has to continue to drop and gap down to find buyers. So, in either case, runaway gaps form as a result of panic trading.

Exhaustion Gap:

An “exhaustion” gap occurs at the end of a price move. If there have been two or more gaps before it, then this kind of gap should be regarded very skeptically. A genuine “exhaustion” gap is filled within a few days to a week. It is generally not easy to distinguish between the Runaway and Exhaustion Gaps. Experience in reading charts will help in due course. The best clue available is that Exhaustion Gaps are not the first Gaps in the chart, i.e. they follow the Runaway Gaps and usually occur when the runaway Gap is nearing completion. Exhaustion Gaps do not indicate whether the trend will reverse, they only call for a halt in the price movement.
This completes our discussion on gaps. I hope it has filled in some gaps in your trading knowledge. Here are some additional hints :-

  • A gap has relevance only to a daily or short term trader.
  • On spotting a gap in a daily chart, immediately question yourself as to which of the four kinds of gaps it is.
  • Generally, short-term trades should be in the direction of the gap. The larger the gap and the stronger the volume, the more likely it is prices will continue to trend in that direction.
  • A “breakaway” gap provides an immediate buy point, particularly when it is confirmed by heavy volume.
  • The third upside gap raises the possibility of an “exhaustion” gap. Traders should look for the gap to be filled in approximately one trading week. If the gap is filled and selling pressure persists, then that issue should be shorted. If the gap is the third one to the downside, then traders should be alert for a buy signal.
  • Gaps are powerful signals to make profits if used intelligently. They should not be acted on in isolation. View the gap within the context of the other technical results.

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Summary of Chart Patterns

Here’s the summary of what we have discussed so far:

Charts

  • Chart analysis is the technique of using patterns formed on a chart to get an idea about the price movement of a share.
  • There are two types of chart patterns: reversal and continuation.
  • A continuation pattern suggests that the prior trend will continue upon completion of the pattern.
  • A reversal pattern suggests that the prior trend will reverse upon completion of the pattern.

Flag and Pennants:

  • Flags and pennants are continuation patterns formed after a sharp price movement. The move consolidates, forming a flag shape or pennant share, and suggests another strong move in the same direction of the prior move upon completion.

Triangles:

  • There are three main types of triangle patterns – symmetrical, descending and ascending, which are constructed by converging trendlines.
  • A symmetrical triangle, which is formed when two similarly sloped trendlines converge, typically suggests a continuation of the prior trend.
  • A descending triangle, which is formed when a downward sloping trendline converges towards a horizontal support line, suggests a downward trend after completion of the pattern.
  • An ascending triangle, which is formed when an upward sloping trendline converges towards a horizontal resistance line, suggests an uptrend after completion of the pattern.

Cup with handle:

  • A cup-and-handle pattern is a bullish continuation pattern that suggests a continuation of the prior uptrend.

Double tops and Double bottoms:

  • A double top is a bearish reversal pattern, which suggests that the preceding up trend will reverse after confirmation of the pattern.
  • A double bottom is a bullish reversal pattern, which suggests that the prior downtrend will reverse.

Head and shoulders:

  • A head-and-shoulder suggests a reversal in the prior uptrend. An inverse head and shoulders suggests a reversal in the prior downtrend

Wedges:

  • A wedge chart pattern suggests a reversal in the prior trend when the price action moves outside of the converging trend lines in the opposite direction of the prior trend.

Rounding Bottom:

  • A rounding bottom  is a long-term reversal pattern that signals a shift from a downward trend to an upward trend

Triple tops and triple bottom:

  • A triple top is a reversal pattern formed when a security attempts to move past a level of resistance three times and fails. Upon failure of the third attempt the trend is thought to reverse and move in a downward trend.
  • A triple bottom is a reversal pattern formed when a security attempts to move below an area of support three times but fails to do so. Upon failure of the third attempt below resistance the trend is thought to reverse and move upward.

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Reversal Patterns 5 : Triple tops and Triple bottoms

Triple top is a bearish reversal pattern formed when a share price that is trending upward tests a similar level of resistance three times without breaking through. When the stock fails to move past the resistance level three times, it is assumed that the stock price would come down. This pattern is difficult to spot in the earlier stages of formation. In the triple-top formation, each test of resistance at the upper end should be marked with declining volume at each successive peak. And again, when the price breaks below the support level, it should be accompanied by high volume.

Example of triple top pattern:

Triple bottom is a bullish reversal pattern formed when a share price that is coming down tests a similar level of support three times without breaking through. When the stock fails to move past the support level three times, it is assumed that the stock price would resume the up trend. In this pattern, volume plays a role similar to the triple top, declining at each trough as it tests the support level, which is a sign of diminishing selling pressure. Again, volume should be high on a breakout above the resistance level on the completion of the pattern.

Example of triple bottom pattern:

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Reversal Patterns 4 : Rounding Bottom

The rounding bottom is a long-term reversal pattern that signals a shift from a downtrend to an uptrend. The pattern resembles the cup and handle pattern but, without the handle. Volume is one of the most important confirming measures for this pattern where volume should be high at the initial peak (or start of the pattern) and weaken as the price movement heads toward the low. As the price moves away from the low to the price level set by the initial peak, volume should be rising. The way in which the price moves from peak to low and from low to second peak may cause some confusion as the long-term nature of the pattern can display several different price movements. The price movement does not necessarily move in a straight line but will often have many ups and downs. What is important is the general direction of the stock price.

Example of a rounding bottom pattern:

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