Reading Gaps in Charts to Find Good Trades (Part 2)

07/20/2010 12:01 am EST

Focus: STRATEGIES

Timothy Morge

President, MarketGeometry.com

(Continued from Part 1)

The unfilled gap right at the beginning of this chart (and if you are like me, you view this entire chart as a whole) is like the winding of a spring in a clock. The unfilled gap shows you this market is rested and ready to move, and it also gives you the direction as clearly as the hands of a clock moving in one direction.

To flesh out the analogy, the three attempts price makes to rally are like the swinging of the pendulum in an old fashioned clock—and each time the pendulum swings back within a confined space or range, it's as if the clock spring is being rewound tighter and tighter. When price breaks below the flat base on the third drive lower, the pent up energy is expended quickly and in one direction: Down!

Is there anything else we can learn from physics about this chart before we move on?

chart
Click to Enlarge

Let's examine this chart and keep in mind the analogy of price being a large clock with a wound spring driving price's movements. First, I measure where the wound spring of the clock was originally released and measure how far it powered price lower before it slowed and then restored its energy, in this case by trading within a tightening range that was marked with a flat bottom. Then I project that same distance from the area where the newly rewound spring was released (where price broke below the flat bottom of its trading range). As a student of physics, it is not surprising to me when the lengths of the two distances are very nearly the same, and in this case, price runs out of downside directional energy at almost exactly the same distance.

Now I am focused on the lowest low on the chart and the bars that follow it. Specifically, I am looking at the very last bar, which is a wide range bar. Does this bar have any significance? Or is this bar just a wide range bar in a cascading downtrend? Let's look at it closer.

chart
Click to Enlarge

I zoomed in so you could see the bars after the lowest low much more clearly. My eyes are drawn to the very last bar on the chart. Price had begun to climb out of the hole after meeting its projected low and had a nice little rally going. It may even have broken above a minor swing high or two. And then something—news, a very large sell order, an overall breakdown of the prices in the stock market—made price open up much lower than the close of the prior day. But even though it gapped open much lower, it found nothing but buyers at the lower levels.

How do I know there were buyers at the lower levels? Price closed near its high. In fact, it closed higher than it did the prior day. There is a trading term that was started in the currency markets in the mid-1980s: When this type of action was seen, large, knowledgeable traders would say that there were “whales feeding there!” In this case, when price gapped open much lower, the average retail trader either sold out or was stopped out of their long position, or worse, they may have even gone short when price gapped open, expecting the prior low to be broken. But a few large traders, the whales, bought all the shares being dumped and then began to buy more, pushing prices higher. Soon those traders who had gone short on the lower opening were buying, covering their losing short positions. And at some point, the retail traders who had been long but had dumped their long positions began to realize price wasn't going lower—not today, at least—and they also began buying, establishing new long positions at higher prices. And so the gap was filled and price closed higher on the day—quite a remarkable recovery!

But does one bar like this mean the selloff is finished? Of course not. Price action must be observed carefully from these levels. Price will tell us when the downtrend is over: If we continue to see buying activity, there will come a point where a change in behavior is obvious.

More tomorrow in Part 3…

By Tim Morge of Market Geometry.com

Related Articles on STRATEGIES