Gaps in Price Charts

Daily Analysis - 22/12/2017

Often gaps appear in charts. What is their significance?

Today’s first signal set included Kion, the German specialty truck and logistics vehicle manufacturer. While the signal sought to exploit the very strong trend in the stock there was a gap in the pricing. Several clients inquired as to the significance of this and all those that did wanted to know why they appear.

On matters of fact concerning technical analysis Investopedia is a terrific source of clear, succinct and highly understandable guidance. We borrow with gratitude from our friends at Investopedia for this piece today. There are four basic types of gaps. We will illustrate them with charts from different stocks.

The Breakaway Gap

A breakaway gap occurs at the beginning of a market move - usually after the security has traded in a consolidation pattern, which happens when the price is non-trending within a bounded range. It is referred to as a breakaway gap as the gap moves the security out of a non-trending pattern into a trending pattern. The chart of FiatChrysler shows three of these gaps. A strong breakaway gap out of a period of consolidation is considered to be much stronger than a non-gap move out. The gap gives an indication of a large increase in sentiment in the direction of the gap, which will likely last for some time, leading to an extended move. The strength of this gap (and the accuracy of its signal) can be confirmed by the volume during the gap. The greater the volume out of the gap, the more likely the security will continue in the direction of the gap.

Human nature vs. Mother Nature

Let’s digress here that we speak of patterns in the charts as if they were patterns of scientific are natural events. They are neither. It is very important that we understand, particularly as beginners that, despite the pseudo-scientific jargon and the high tech look of the studios of the financial media, the NASA like trading stations of brokers and traders that we are traders in the CAPITAL markets. What we chart and analyze what indeed we are looking at entirely is a HUMAN phenomenon. As such, there is a high degree of randomality about what goes on in these markets. After all is said and done, these charts graph the activity, and in a way the emotions behind the human BEHAVIORS in those markets. Economics and its subset finance is a Social science not a natural science. And so let’s put a sharp point on this matter before returning to our subject of gaps by stating unequivocally the stark difference between natural science and social science. In natural science laws of nature prevail. When a phenomenon is proven to be a law it will hold in all cases of reality. An object of a known mass rolling down an incline of a known slope will accelerate at a known rate. Period. Nothing of the sort holds in social science. The best we can hope for is a state wherein we can say with “degrees of certainty” i.e. probability, what is likely to occur given a certain set of circumstances. Natural science is deterministic. Social science is probabilistic. Therefore, trading the capital markets is an art or craft. It is not a science.

Runaway Gap

A runaway gap forms after a trend has started, usually after the price has made a strong move. It indicates that the current trend will continue indicates renewed or new interest in the security. The Telefonica chart is an illustration of this gap type. After a security has made a strong move, many of the traders that have been on the sideline waiting for a better entry or exit point decide that it may not be coming and if they wait any longer they will miss the trade. It is this increased buying or selling that creates the runaway gap and continuation of the trend. Volume in a runaway gap is not as important as it is for a breakaway gap but generally should be marked with average volume. If the volume is too extreme, it could signal that the runaway gap is actually an exhaustion gap (discussed further in the next section), which signals the end of a trend.

Exhaustion Gap

This is the last gap that forms at the end of a trend and is a negative sign that the trend is about to reverse. This usually occurs at the last expressions of a trend (typically marked with fear or panic), but can also be the point when weaker market participants start to move in or out of the security. The graph of Nicox is the illustrator of this gap type. The exhaustion gap sot of gives the feel of irrationality, euphoria like when an asset is being hyped as "a can't-miss opportunity" or conversely as something to "avoid at all costs".

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