Reading Gaps in Charts to Find Good Trades (Part 3)

07/21/2010 12:01 am EST

Focus: STRATEGIES

Timothy Morge

President, MarketGeometry.com

(Continued from Part 2)

This particular bar is interesting because of the failure of the large gap lower to hold, but at the moment, it is just something interesting to file away in the back of your mind as you watch price unfold from this point. Let's watch price unfold a bit and see what we notice.

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First, let's find that wide range bar that gapped lower but closed higher—and you can see I marked it on this chart. You can see that bar did not signal price was about to skyrocket higher; instead, it was indeed something to file away in the back of your mind. There were “whales,” or large traders, willing to buy this stock as it traded towards its prior low.

Depending on the length of your holding period and how much risk you are willing to place upon your account, you can do different things with this information:

  • If you are a long-term investor looking to add long-term positions to your portfolio, there may be a price down near the prior low where you are willing to buy some of this stock (it is a major company and has a very large daily volume, by the way) with a stop loss 30 to 50 cents below the prior low.

  • If you are a trader who uses daily bars when trading stocks and has a holding period of days or a few weeks, you may be willing to watch price action before deciding where this stock is heading. You may be willing to trade time and price to get more information before you make a trading decision. Since I am a trader, not an investor, I am always willing to make this tradeoff.

So I watched patiently. As it traded lower from the wide range bar that gapped lower and closed higher and headed towards the prior lows, I had no sign from price that a change in behavior had occurred. I was willing to watch as price declined to see if the whales were still buying at lower levels, and to get me interested in getting long this stock, I would need to see some signs of strength.

Price traded lower but was unable to approach its prior low. Then price began to stair step higher. As I watched patiently, I began marking swing highs and swing lows. Price eventually climbed above two swing highs that I had marked from the prior move lower (marked in dashed red lines), a measurement I generally use to tell me to pay attention, a change in behavior may in the making.

But let's go back to the clock spring analogy again: Price has climbed higher and it has taken out two prior swing highs. But it stopped right where the clock spring should have run out of directional energy if price was still vibrating with the same frequency. Price has now retraced 50% of its selloff, the amount of potential energy price found each time in the clock spring on the way down. To get me interested in buying this stock, I need a sign of strength, and I need to know there are buyers at higher levels.

Or perhaps I will be a seller as price retests the 50% retracement area.

Or perhaps I will continue to wait.

My actions at this point will depend on what price shows me next.

Article Continues on Page 2

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Price rallied even further, breaking above the halfway point marked by the blue multi-pivot line. It also left several unfilled gaps on the way up. Now price may have topped out. It has broken below several swing lows made during this current rally, a sign that generally makes me pay attention in case a change in behavior has taken place.

But look carefully at the last bar on this chart. Price has sold off below two prior swing lows, and these are signs of weakness. It tried to enter and fill an unfilled gap, but it failed to fill that gap. It gapped lower inside the unfilled gap, but closed near its highs. This is a sign of strength. Is this a sign that whales are interested in buying at these higher levels?
In my mind, the next bar should give me key information:

  • If price turns lower and fills the currently unfilled gap, price is likely headed lower.

  • If price heads higher, leaving this gap unfilled, it is a sign of strength, a sign that the whales missed this move higher (I certainly chose to sit on the sidelines while this stock rallied quite a bit) and have an interest to buy at this unfilled gap.

  • If price trades quietly for a bar or two, which is always possible, I'll simply wait for price to show its hand. I believe price is now at a level where the next move will give me a clear direction.

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Price gives me an indication that the whales have left limit buy entry orders at the unfilled gap area. I cannot overstate how much of an edge you have as a trader when you have the ability to read where the large buy or sell orders are sitting in the market by the price action on a simple bar chart. I learned this ability because I was one of the five or six cash forex traders who spawned the original term “whales” in the mid-1980's. It was easy for me to see my own “tracks” on a bar chart because I knew what orders I was working in the market and how these orders showed up in the price action. And I quickly learned what the “tracks” of the other whales looked like that traded in my active time zone. Eventually, the similarities of the whale tracks became apparent and it became second nature to me to be able to see these signs on a bar chart.

More tomorrow in Part 4…

By Tim Morge of MarketGeometry.com

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