Gauging Gaps

CHARTING

Can Gaps Make You Money?

Gauging Gaps Should you trade the gap? Here are some gap performance numbers to help you decide. by Thomas N. Bulkowski uppose you've been following a chart pattern. Say prices gap upward, piercing the trendline in a breakout. Do you buy the stock, expecting an unusually large gain? How long will it be before prices return and close the gap? I will address those questions here. GAP TYPES Prices gap when today's high is below yesterday' s low, or today's low is above yesterday's high. A chart of the pattern will show a gap between the prices. There are five types of gaps: area, breakaway, continuation, ex-dividend, and exhaustion. Figures 1 and 2 show examples. Common and pattern gaps are synonyms for the area gap. As you can see in Figure 1, area gaps appear most often, usually during a sideways price trend. Prices usually, but not always, close the gap quickly, meaning that they return to the gap location and span it completely, filling the hole left by the gap. For example, the area gap in November closes a week later, but the early December breakaway gap doesn't close until almost February. Exhaustion gaps typically appear at the end of a straight-line run, as they did in December and October. Measuring and runaway gaps are synonyms for the continuation gap. Figure 2 shows an example. It's a rare gap, and it too makes its appearance during straightline runs, with prices continuing to move in the prevailing direction. GAP IDENTIFICATION Figure 3 shows the identification guidelines forgaps. To describe them more thoroughly:

FIGURE 1: AREA, BREAKAWAY, AND EXHAUSTION GAPS. Area gaps are the most common, with breakaway gaps giving the best performance.

FIGURE 2: MORE GAPS. A continuation gap usually follows a breakaway gap.

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Area gap. The area gap occurs most often. It looks like a breakaway gap at first, but it closes quickly. Volume may be heavy the day the gap occurs, but usually returns to normal in a day or two. Look for a sideways congestion or consolidation region spawning the gap. It's as if prices pump pressure for the explosive move, but the pressure dissipates quickly. In some cases, a distinctive hooking pattern occurs. The early May area gap in Figure 1 shows this curling pattern when the gap closes two days later. Breakaway gap. If there is one gap type to trade, it's the breakaway gap. Prices break out of a consolidation region on high volume, setting the stage for a ballistic, straight-line run. High volume typically persists for several days and the gap does not close quickly, which distinguishes it from the area gap. It's been said that the longer the congestion area preceding the gap, the more strength the breakaway will have, but I haven't researched this to know if that's true.

IDENTIFICATION GUIDELINES GAP TYPE

IDENTIFICATION

Area, common, or pattern

Look for a congestion area preceding the gap. Volume may be high, but it returns to normal quickly. Sometimes prices gap, then curl around in a distinctive hooking pattern, closing the gap in a few days. Area gaps tend to be short.

Breakaway

A gap associated with high volume at the start of a straight-line run, usually after the breakout from a consolidation area. High volume may continue for several days.

Continuation, measuring, or runaway

Occurs in the middle of a straight-line run on high volume. Measure from the trend start to the gap and project upward to predict where prices will stop.

Ex-dividend

Prices gap downward when the stock pays a dividend, but price action during the day usually closes the gap.

Exhaustion

Often a large gap signaling the end of a straightline run, accompanied by high volume. Prices sometimes retrace and close the gap quickly.

FIGURE 3: Gaps are easy to identify after they occur, but not on the gap day.

Continuation gap. The continuation gap may be hard to distinguish from an exhaustion gap, except that prices do not close the gap quickly. This gap usually occurs after a breakaway gap, during a straight-line run on high volume.

The gap signals that the price rise isn't over. I measured the position of the continuation gap in the price move and found that it resides almost halfway (48% of the way) to the trend's end. Hence, that's why some call it a

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CHARTING

measuring gap, as you can use it to predict when the price trend will end. The continuation gap in Figure 2 shows this midway behavior. Ex-dividend gap. I don't show this gap type because it is rare. It occurs most often in utility stocks and other securities with large dividends. On the day the company distributes the dividend, the stock gaps downward. Succeeding price action usually closes the gap before the end of trading.

GAP STATISTICS Gap Type Area Breakaway Continuation Exhaustion

Average closing Closed in one Closed in one time (days) week(%) year(%)

6 83,86 70,43 23,17

90 1,6 11,10 58,72

98 76,66 87,95 98,98

Note: No trend direction appears for area gaps. Otherwise, the first number is for uptrends, the second is for downtrends.

Exhaustion gap. The exhaustion gap signals the end of the trend. If you see a very large gap at the FIGURE 4: Prices cover area gaps in less than a week, but breakaway gaps take two months end of a trend, it's probably an exhaustion gap. to close, on average. Volume is usually heavy, and the gap closes quickly. That's what distinguishes it from a continuation gap. Prices usually reverse direction after an exhaustion gap, a continuation gap. Consider the continuation gap as a marker providing a short-term trading opportunity. Figure 1 shows for the midway point of the trend, and project accordingly for this in the exhaustion gaps, with the September retrace being the predicted price move. If a gap appears at the end of a trend, it's probably an exhaustion gap. the most pronounced. GAP STATISTICS Figure 4 shows the average closing time for gaps. By that, I mean the time it takes prices to fill the gap or the percentage of gaps in which prices covered the gap in a set time. Since area gaps occur frequently in consolidation trends, no up- or downtrend numbers appear. The results show that the average time for area gaps to close is just six days. This compares to 86 days for breakaway gaps in a downtrend. How many gaps close within a week? Nearly all area gaps (90%) do, but few breakaway gaps close in that time: 1% in uptrends and 6% in downtrends. How many gaps close within a year? I expected that most of them would. The exhaustion gaps tie with the area gaps, both at 98%. Again, breakaway gaps show the fewest closing a year after their appearance, which attests to the strength of the initial push. Please note that all figures pertain to the recent bull market, not the current bear market. What do all of these numbers mean? If you buy a stock showing a gap and the gap closes quickly, it's probably an area gap. If a price trend develops, it's probably a breakaway gap. If the gap doesn't close quickly and a trend is already in progress, then it's most likely

Do you buy the stock, expecting an unusually large gain? How long will it be before prices return and close the gap?

TRADING Take a look at Figure 5. It shows a symmetrical triangle with a gap during the breakout; the gap closes during the throwback. Ignoring the gap type, I scanned my database of the most common and popular chart patterns and found those with gaps on the breakout, like the one shown. Then I measured how far prices climbed (upward breakouts) or fell (downward breakouts) from these chart patterns. Next, I compared them to the same chart pattern types without gaps. Which do you think performed better, those showing a gap on

FIGURE 5: SYMMETRICAL TRIANGLE WITH GAP. Do chart patterns showing gaps on the breakout day perform better than those not showing gaps?

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the breakout day or those GAPS AND PERFORMANCE without a gap? Figure 6 shows the statisChart Pattern Rise/decline Rise/Decline Which is better? tical results. For bullish chart with gaps without gaps patterns (the top half of the 29% Double bottoms, Adam & Adam 27% Gap figure), five patterns showed 26 Double bottoms, Adam & Eve 33 No gap prices rising farther when a 41 Double bottoms, Eve & Eve 35 Gap gap occurred on the breakout day, three performed worse, 30 Double bottoms, Eve & Adam 30 Tie and three tied. 34 34 Head & shoulders bottoms Tie Bearish chart patterns (the 42 35 Rectangles, up breakouts Gap bottom half of Figure 6) did Scallops, ascending, up breakouts 25 26 No gap better with gaps too. All but Scallops, descending, up breakouts 19 16 Gap three patterns performed better when a gap appeared on Triangles, descending, up breakouts 52 40 Gap the breakout day than when Triangles, symmetrical, up breakouts 33 36 No gap no gap appeared. 34 34 Triple bottoms Tie For bullish patterns, I meaDiamonds, down breakouts 18 23 No gap sured from the breakout price Double tops, Adam & Adam 21 17 Gap to the highest high before prices closed 20% lower; for Double tops, Adam & Eve 18 15 Gap bearish patterns, I measured Double tops, Eve & Adam 15 16 No gap from the breakout price to Double tops, Eve & Eve 19 18 Gap the lowest low before prices Head & shoulders tops 22 20 Gap closed 20% higher. Scallops, ascending, down breakouts 12 13 No gap If you look at each row, in some cases there is no differScallops, descending, down breakouts 21 15 Gap ence between gap and no-gap Triangles, descending, down breakouts 18 17 Gap performance. In many cases, Triangles, symmetrical, down breakouts 23 Gap 19 the average rise or decline I Triple tops 24 Gap 18 measured is close. For example, descending triangles FIGURE 6: Price performance of stocks after a gap on the breakout day compared to those without a gap. The top half of with down breakouts (third the figure shows bullish patterns; the bottom half shows bearish patterns. entry up from the bottom) show prices declining an average of 18% when a gap occurred during the breakout, versus a 17% average decline for triangles missing a gap. Gaps perform better, but not by much. To summarize, gaps improve performance, but in many cases the improvement is meager. In short, don't get too excited the next time you see a gap appearing during a breakout. Contributing Writer Thomas Bulkowski is the author of two books, Encyclopedia Of Chart Patterns and Trading Classic Chart Patterns. He may be reached via email at

tbul@hotmail. com. SUGGESTED READING Bulkowski, Thomas N. [2000]. Encyclopedia Of Chart Patterns, John Wiley & Sons. [2002]. Trading Classic Chart Patterns, John Wiley & Sons. Charts by Thomas Bulkowski fSee Traders' Glossary for definition

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