This chapter is from the book
This chapter is from the book
This chapter is from the book
How to Use Gaps in Trading
How might a trader, seeing a gap, react to the information? If the trader thinks that the gap is a breakaway gap, he would want to trade in the direction of the gap. In other words, if a breakaway up gap occurred, he would assume an uptrend is beginning and take a long position. If a breakaway down gap occurred, he would assume a downtrend is beginning and take a short position. He would also want to trade in the direction of the gap, if the stock were trending and a gap occurred that he thought was a measuring gap. Throughout this book we refer to trading in the direction of the gap as a continuation strategy in that the trader is expecting the price to continue in the direction of the gap.
If a trader sees a gap she thinks drives the price up so much that there is little room for the price to push higher, she would want to trade opposite of the gap. Suppose, for example, a pharmaceutical company announces that it has received FDA approval for a new drug. Upon the release of this good news, the stock gaps up. If the trader thinks that the market is over-reacting to this good news, she would want to short the stock. Likewise, if she thinks that market players have driven the price down too low on a gap, she would want to take a long position. Remember the old adage that a gap must be filled. The notion that a gap is always filled is based on the idea that the market players do not like to see a hole or a void in a price movement and will work to fill that gap. We refer to trading in the opposite direction of a gap as a reversal strategy.
Traditional technical analysis theory would tell you to trade breakaway and measuring gaps using a continuation strategy. You might want to trade an exhaustion gap with a reversal strategy; however, a major problem is that traditional theory has not provided a sound way to classify a gap as it occurs. It is only in hindsight that you can tell if a gap was a breakaway, measuring, or exhaustion gap.
The main task in this book is to help you pick up on clues as to what type of gap may be occurring so that you can enter successful trades. Chapter 2, “Windows on Candlestick Charts,” discusses traditional Japanese candlestick patterns that contain gaps. Chapter 3, “The Occurrence of Gaps,” looks at the occurrence of gaps and considers the frequency of gaps, the distribution of gaps across stocks, and the distribution of gaps over time. Chapter 4, “How to Measure Returns,” discusses our methodology for determining profitable gap trading strategies. Chapter 5, “Gaps and Previous Price Movement,” considers what clues the price movement leading up to the gap gives you to form profitable trading strategies. Because volume is an indication of how important a particular day’s price movement is, Chapter 6, “Gaps and Volume,” considers the relationship between volume and gap profitability. To determine whether gaps that occur at relatively high prices have a different significance than those occurring at average or relatively low prices, Chapter 7, “Gaps and Moving Averages,” considers the location of gaps relative to the price moving average. Although most of this book focuses on individual securities, you can look at the relationship between gap significance and underlying stock market activity in Chapter 8, “Gaps and the Market.” Chapter 9, “Closing the Gap,” covers the often-heard phrase, “A gap must be closed.” Last, Chapter 10, “Putting It All Together,” provides an overall summary of how gaps can be used as part of an effective trading and investment strategy.
Endnotes
Bulkowski, Thomas N. “Bulkowski’s Free Pattern Research,” http://www.thepatternsite.com, 2010.