How to Trade Price Gaps (Part 2)

09/18/2009 12:01 am EST

Focus: STRATEGIES

John Jagerson

Co-Founder and Contributor, LearningMarkets.com

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.

In Part 1 of this 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 October 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.

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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.

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As you can see in the chart of Exxon Mobil (XOM), the breakaway gap on June 22 occurred on high volume and ultimately lead to four 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.

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The breakaway gap that occurred in April on Google (GOOG) looked good, but it ultimately 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.

Watch the video for more information:

By John Jagerson of LearningMarkets.com.

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