How to Trade Price Gaps (Part 3)

09/21/2009 11:07 am EST

Focus: STRATEGIES

John Jagerson

Co-Founder and Contributor, LearningMarkets.com

Like breakaway gaps, a continuation gap represents a shift in investor sentiment. Specifically, a continuation gap on higher-than-average volume represents renewed interest in the current trend. A continuation gap reflects that increased interest with higher-than-average volume and a bigger-than-average price move.

Because a continuation gap occurs in the middle of a trend, it is a significant warning that risk is very high for counter-trend traders and may be an interesting entry opportunity for new trades. A continuation gap can occur within a downtrend or an uptrend. You can see an example of this kind of gap in the image below.

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In the image above, Apple, Inc. (AAPL) gapped up in the middle of a trend. This continuation gap occurred following a breakaway gap a couple weeks earlier, which is not uncommon. The higher-than-average volume level confirmed the new buying demand behind this gap. The appearance of so many continuation gaps towards the end of 2008 was a big tipoff that the stock market was in serious trouble. You can see an example of this in the chart below.

chart
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You will find that like with most analytical methods, there is room for personal preference and interpretation. The definitions of breakaway, common, and continuation gaps overlap, and experience is needed before you will feel fully comfortable taking trades based on these price patterns. As you practice identifying gaps, there are a few more concepts you should keep in mind.

Most Gaps Close...Eventually

Gaps are like a vacuum on the price chart. Most large gaps will be filled within a year. The average time for a gap to be filled in the stock market is three months. This means that if a stock gaps down, there is a very high likelihood that prices will come back up and through the gap within a year. The same is true of bullish gaps, only in reverse.

This means that using gaps as a trading signal is a short-term strategy. However, even long-term traders can benefit from the analysis by using gaps to time new entries or periods of time when risk is higher and hedging is needed.

Not All Markets Gap

The retail forex is a classic example of a "gapless" market because it is open five days a week and 24 hours a day. However, the same psychology that causes a gap in stocks exists in the forex. A much larger-than-average move following unexpected news represents the same kind of underlying forces that cause a gap in a stock's price. You can see an example of a continuation "gap" and dead cat bounce in the chart of the USD/CHF currency pair below.

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Volatility = Higher Risk

An immutable law of the markets is that when there is greater profit potential, there is higher risk. Gaps are inherently volatile and unusual market volatility is hard to predict. Gaps are attractive trading opportunities because the subsequent price moves can be very large. However, sudden reversals, market exhaustion, and whipsaws are also common.

Some traders may use stop losses and tight money management to deal with this risk, while others may use options to try and limit risk. In either case, the important principle is to control your risk and to be alert to changes in the market. Practicing gap trading in a paper-trade account is also a good way to make sure you understand the risks and nuances of trading short-term price patterns like gaps before putting real money at risk.

Watch the video now for more information:

By John Jagerson of LearningMarkets.com.

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