Reading Gaps in Charts to Find Good Trades (Part 1)

07/19/2010 11:12 am EST

Focus: STRATEGIES

Timothy Morge

President, MarketGeometry.com

One of the most rewarding and challenging things I have done in my 40-year trading career is teach elementary school students the basics of technical analysis and how to apply those basics in order to make money trading stocks. Each student comes to the trading class with a fairly clean slate: They don't know much, if anything, about the markets and they don't carry any of the emotional burdens of having to make “real” money to pay the rent or buy food. They soak up what I am willing to teach, which is a delight, but once they soak it up, they roll it around in their heads and then ask some of the most thought provoking questions!

When starting with an unmarked chart of a stock, I often point out market structure: Swing highs and lows, ranges, double or triple tops or bottoms, and gaps. On one particular afternoon, I started with a chart and began marking out simple market structure, and after a few minutes, the questions began. Why did I place any significance when price gapped higher or lower? Did it matter if the gaps remained unfilled or were all gaps the same? If gaps are important, how can you use them to make money?

This is the chart I started with:

chart
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Then I began to draw in what I considered to be the significant market structure, the “Don't Miss These” things that each of them should see when they first examine an unmarked bar chart.

chart
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On the unmarked chart, the first market structure that caught my eye was the unfilled gap that price left right as the downturn began in earnest, and of course, I may have noticed it first because we generally look left to right.

chart
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With the unfilled gap out, I added another easily spotted structure—“Three Drives to the Top”—and these were particularly easy to spot because each top was lower than the prior top. Once I marked the three drives to the top formation, its twin formation became evident:

chart
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This particular set of three drives to the top and three drives to the bottom are generally very reliable because the tops are forming lower and lower highs and the bottoms were forming a flat base. One of two outcomes flow from this set and the resulting move is generally explosive:

  • Either a fourth drive to the top breaks above the prior three highs (and remember, each of the three are swing highs so a break above this formation should indicate a change in behavior), or…
  • The third drive lower fails to hold at the test of the flat base (or a minor rally following the third drive runs through the flat base). While forming this flat base, price has been restoring energy, and when the bottom is violated, it generally moves a good amount to the downside.

Let's look at the interplay of the market structure I have marked so far:

chart
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When I view these formations, I like to take them apart in my mind and think in terms of the physics behind the market structure, which is how one of my earliest mentors, Dr. Alan Andrews, taught me to think about the markets.

More tomorrow in Part 2…

By Tim Morge of MarketGeometry.com

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