What You Need to Know About Gaps

By editorial@smallcapinvestor.com (Ian Wyatt),

Shutterstock photo

We're wrapping up our holiday review of technical analysis methods today by looking at two key patterns.

Wedges: The wedge pattern signals a reversal in the current trend. The wedge is similar to the triangle, but tends to take much longer to develop. The wedge term could also be as long as several months.

It demonstrates a convergence of resistance and support over this period, while overall price levels trend upward or downward. So the wedge contains a narrowing trading range while signaling price direction change. In a falling wedge, the sentiment is bullish because you would anticipate a price reversal to the upside at the end of the wedge.

The slope of the top, or resistance, is probably going to be sharper than the slope of the descending support line, which may even be flat. Within the wedge, expect to see at least two tests of both resistance and support. These double tops and bottoms are part of the wedge development.

A buy signal occurs when the price finally breaks through resistance and begins moving upward. This normally is also accompanied by heavier than normal volume. The rising wedge is exactly the opposite. It demonstrates an ascending and narrowing price range. It is bearish, and you should expect price tests on the top and the bottom, culminating in a breakout below support. This is a sell signal at the conclusion of the wedge.

Gaps: Any time a space is found between one period's closing price and the next period's opening price, a gap has been formed. A "period" is normally a single trading day, but some traders (notably day traders and micro traders) also track 15-minute or 5-minute charts, looking for important signals.

One important attribute of chart patterns is that all of the generally observed significance to patterns applies whether in very short periods or over extended periods of time. In the stock price illustration below, note the narrowing trading range in the form of a pennant, ending with an important combination of an upward price gap and a following strong breakout to the upside.

Gaps in a Stock Chart, Source: Yahoo! Inc.

There are many different kinds of gaps. A common gap is found in any stock with even moderate volatility and does not really signal any change in the current trend. But runaway and breakout gaps are very meaningful. A runaway gap involves a series of gaps, one after the other and in the same price direction. A breakaway gap occurs when the gap itself moves price through resistance or support.

These gaps generally are the start of a major price movement. As the short-term trend begins to end, an exhaustion gap is likely to occur, which is either accompanied by or shortly followed by high volume. This normally signals that prices are going to stop moving in the current direction and move in the opposite direction. These are generalizations, but they can be useful for confirming trends noticed by other signals, such as double tops or bottoms, head-and-shoulders patterns, and changes in volume.

The chart below shows three the types of gaps, which often will be seen as part of a short-term trend within a short period of time.

Three Types of Gaps, Source: Yahoo! Inc.

The Bottom Line on Technical Analysis

  • Technical analysis can compliment fundamental research, helping determine the timing of trades to maximize profits.

  • Institutional investors can use technical analysis for program trading based on the technical movements of stocks.

  • Stocks trade within ranges, and when those ranges are violated, share prices are likely to move either higher or lower, depending on the direction of the movement.

  • Breakouts on heavy volume are a better indication of the direction than those that occur on low share volume.

  • Technical analysis can be effectively used to determine the short-term direction of a stock.

  • Long-term, stocks move based on the fundamentals, not based on the technicals.

Just like most things, understanding technical stock price movement takes practice. But to a trained eye, a stock chart can give the astute investor an idea where the stock price may go. Practice before you act, and gain confidence. You'll be glad you did when you start to make profitable trades.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing Stocks
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