The Importance of Gaps: It's Where They Fall within a Trend That Counts
Gaps are one of the most interesting, and instructive, developments in all of technical analysis. A few hours of study devoted to gaps can pay handsome rewards to investors.
Gaps are simply price ranges where no transactions take place, therefore the term “gap.” Gaps are the result of a temporary supply/demand imbalance, with prices either jumping sharply or dropping sharply, until a balance is restored. As technical analysis is the study of the demand/supply variables underlying price, gaps can be very instructive.
The particular importance as to forecasting implications, however, depends on where the gap occurs. Sometimes gaps have a great deal of significance; sometimes gaps have very little significance. Any importance of a gap depends on where within the trend the gap develops.
Most gaps appear within a pattern, within an area of trading, and have very little significance. Within most any type of pattern, prices will be backing and filling, seesawing, with frequent “area” gaps in evidence. The implications of these pattern gaps are nil.
However, a most significant gap is the “breakaway” gap, which, as the name implies, occurs when prices are breaking out of a pattern. The implication of breakaway gaps is important.
In Figure 1, Charles Schwab stock had traded in the mid-20s for nearly a year, back and forth. The overall pattern might be described as a rectangle, with demand (or support) evident at 22 and supply (or resistance) at 27. Notice the frequency of area gaps within the rectangle.
However, the demand/supply balance was to change on November 7, and the stock soared, moving out of its preceding rectangle, gapping to new highs on very heavy volume. Daily volume had been running at a little under 400,000 shares. On the gap breakout, volume swelled to its highest level in a year at over two million shares. Without any question, the breakaway gap on November 7 signaled that the trend in Schwab was bullish.
The space in prices defines the gap, to be sure, but volume plays an important role. For one, higher volume associated with the gap confirms the significance of the breakout—no questions as to the validity of the breakout. However, volume will play a role in defining future support and resistance levels.
On November 7 the stock opened for trading at 28½, rose to a high of 301/8, and closed at 29¾. The huge volume associated with that price level will define where subsequent support should be expected to develop.
Consider the definition of support. Most popular definitions of support state that it is simply the point at which a stock had stopped falling. In other words, the decline stops—it must be support!
However, what is important is that “expected” support levels can be determined beforehand, allowing investors to anticipate, instead of just to react. The volume associated with gap breakouts is an important benchmark in judging where support should be expected to develop.
And, as would be expected, there were several pullbacks in Schwab over the next six weeks, all pulling back to the 28–29 level, but no lower. Volume at 28–29 on the breakaway gap marked that price level as being support. One of the basic rules of buying is to buy “at support,” and that support level was clearly indicated.
The entire formation during November and early December could be described as a descending triangle. Note how there was a small gap on December 19 as prices popped out of that formation.
Over the subsequent two months, Schwab advanced during the mark-up phase. Sometimes during the mark-up phase there will be continuation gaps, but generally, a stock has to be really “hot” in order to have continuation gaps. Schwab’s mark-up, while rapid, was marked by periodic big price jumps, but not gaps.
Until February 13.
On February 13, Schwab developed another type of gap—the exhaustion gap, as prices gapped when the stock crossed 40.
During the development of a trend, a stock will have different phases. The stock will first undergo accumulation, as did Schwab did in the mid-20s. Next, the breakout will represent the start of the mark-up phase, and Schwab was marked up rapidly from 30 to 40. The exhaustion gap often represents the end of the mark-up phase.
At the time of the exhaustion gap, Schwab looked plenty bullish. Nothing looks more bullish than a stock that has just risen 50%. However, trends do not end with a whimper. Trends end with a speculative bang, and the exhaustion gap of February 13 represented such a bang. The exhaustion gap was not accompanied by much volume.
Schwab stock worked a little higher, but on February 19 there was a dramatic reversal. The stock opened at 41, rose to a high of 42, but closed the day on the lows, at 403/8. The following day the stock dropped quickly through the prior exhaustion gap, as there was very little support. No volume, no support. The stock continued to slide into the first week of April, where it again encountered the support at 30 and rallied on a pick-up in volume.
Selling Panic Gaps
Gaps can be very instructive, but it is best to know where exactly, within trend development, that the gap occurs. Of course, gaps can develop in either direction.
Indeed, one of the most instructive patterns I have found has been the selling panic gap. Since many of the best capital gain opportunities are in turnaround situations, tracking selling panics and their aftermath can enable a nimble investor to get into a promising situation early on, if entry is merited.
The typical phases of a downtrend are the mirror image of the uptrend—distribution, mark-down, and selling panic. While investors who own a stock don’t take much solace from the different phases of a downtrend, investors speculating on a potential turnaround will find them extremely well-defined and relatively easy to analyze.
Apple Computer is shown in Figure 2, and it does not take too much focus to see the magnitude of the selling panic gap of January 6.
Apple Computer is chosen as an example not only because of its technical features, but because the stock is probably one of the best known “names” that is currently down and out. The stock topped out way back in 1991 at 73¼.
Apple’s negative fundamentals are well-publicized. Many analysts question Apple’s ability to survive as a going concern. However, good capital gain opportunities arise in such “depressed” situations if the stock shows the right patterns. Investors just have to listen to what the stock is telling them.
Selling panic gaps do not occur in a vacuum. They occur as support gives way. In the Schwab example, the stock gapped as resistance was overcome. In Apple, the stock gapped lower as important support gave way.
Support for Apple was at 21, a price level which was initially established as support back on July 18 as prices gapped higher on that day. Since volume, as well as price, defines significance, the high volume on that day established 21 as a potentially important support level.
In mid-September prices drifted down to that level. Subsequently the stock rallied.
By the end of December, prices had once again drifted down to the support level at 21. Once through support, the stock dropped in the vacuum.
On January 6 the stock opened at 175/8, rallied as high at 183/8, sold as low as
171/8, and closed at 177/8. Volume expand-ed to 16.8 million shares.
Again, the importance of the price level 17–18 is defined not only by price, but by volume. And, just as volume during breakaway gaps tends to lend support for subsequent price activity, volume in selling gaps tends to be resistance.
And, the logic continues that as long as that resistance level stays intact, the stock will be in a bearish trend. However, when and if, that resistance level can be overcome, then the trend will be defined as being bullish.
Following any selling panic, prices generally sell off in “distress” trading for a number of days to a number of weeks. Apple, following some relatively high volume days of churning between 17 and 18, began to sag. With each new low, there was a pick-up in volume. The stock sagged to a low of 151/8 on February 4.
Subsequently, following selling panics and the customary short period of distress selling, there is the typical reflex rally. Apple had such a rally on February 19.
Reflex rallies may be due in part to bargain hunters and, in part, to short covering. However, nearly all reflex rallies rise right to the resistance created with the selling panic and no further, in this case the 17–18 level.
The high of the day on February 19 was 177/8, which correlated precisely with the close of the panic selling gap on January 6 of 177/8. Technical analysis is not supposed to be precise, but sometimes it works out that way. Subsequently, the stock drifted down to the 15–16 level once again.
Normally this stage, after the pendulum has swung back, is the moment of truth. As investors weigh the outlook for the firm, either the stock will drop to new lows, or the stock will start to work its way higher in a series of minor zig-zags.
Well, with Apple, the supply/demand equation took a big turn as first the chairman of Oracle was reported as being interested in bidding to take control of Apple, and then a Saudi Arabian prince said that he now controlled more than 5% of the stock. Amid the takeover speculation, the stock jumped to 19.
However, while takeover speculation punched the stock higher, there is massive resistance at 20–21. So while the variables are now different at Apple than in the typical turnaround situation, the stock picture does reflect demand by excited buyers at 19, but also a ready supply of sellers at 20+ looking to cut their losses short.
Under the proverb that “a bird in the hand is worth two in the bush,” the resistance levels would suggest that joining the takeover fray is about the last resort investors should take.