Trading

Education

When Nothing Means Something

(This is the fifth in a series of articles on basic technical analysis originally published in Futures magazine.)

Trying to discern some type of pattern on a price chart sometimes comes down not to what the price is doing but to what it is not doing. No-trade zones where the price bars seem to skip a beat form so-called "gaps" -- places where no trades take place from one time period to the next.

Like most other aspects of chart analysis, the interpretation of gaps is subjective, and their value may depend on a number of factors, such as the context in which they appear on the chart, the volume of trading on the gap bar, follow-up price action, etc. Early in a contract's history or in a thin market, gaps may be numerous and, consequently, of little importance. But, in actively traded markets, gaps can be an excellent gauge of market psychology and even used to determine potential price targets.

There are four gaps of significance: The "breakaway gap" that occurs at the end of one move and the start of another, the "runaway gap" that may result from some dramatic new development that propels a market higher or lower, the "exhaustion gap" that suggests the possible end of a move and the "measuring gap" that can indicate the halfway point of an extended move. Of course, in the art of chart analysis, defining these gaps can be tricky without the benefit of hindsight. What is clear, however, is that gaps do tend to show up at critical points on the charts, as the accompanying chart of sugar futures illustrates.

Perhaps the most reliable gap signal is the breakaway gap, which often occurs in conjunction with the breaking of important trendlines or support / resistance points and reinforces the validity of the signal. In an uptrend, the high of the current bar falls below the low of the previous bar and below a trendline, suggesting that the market has suddenly run out of new buyers and completed its advance.

When the gap shows up on the chart, the market has a tendency to attempt to "fill" the gap as soon as possible, just as the market often tries to test the breaking of a trendline, flag or other pattern by coming back to the breakout point. The gap can act like a magnet that pulls prices into the zone where no trading occurred, or it can act as an area of support or resistance.

In early January of 2007, the sugar futures market left a gap when it was approaching an important support line near the bottom of the right shoulder. This became the start of a long down trend that lasted until the beginning of February. When sugar futures later broke below $10.00 at the end of March, the prices came back up to test the price but did not fill the gap just above $10.00. That failure helped to confirm a weak market. Traders could have taken several different approaches to using these gaps for positioning their orders.

Sometimes, gaps can be detected in what turns out to be the middle of a move. At the time they take place, you cannot be sure what kind of gap it is, of course, but some traders view a gap as a continuation signal and use it like a flag or pennant formation to calculate how far a move might go. The sugar chart broke from the neckline of the head-and-shoulders at approximately $11.25 to a tiny gap at roughly $10.62, or approximately 62 cents. Assuming the gap was a good sign of ongoing weakness and trying to figure out how low the market might go, a trader would subtract 62 cents from the gap area to arrive at a potential target low of approximately $10.00. In this instance, that coincided with an earlier fall low (not shown by a dotted line) and made the target more plausible.

Some market moves get carried away with momentum that shows up in a series of gaps as a move accelerates. Thinner markets, such as lumber, orange juice or pork bellies, have provided some examples where gaps show up in a dot-to-dot pattern of several limit moves in a row. These gaps do not provide much tradable information.

When these types of markets run out of steam, the trend may end with exhaustion gaps and / or wide-ranging days. On the sugar chart, the sellers still wanted to get on board the downtrend, and buyers weren't willing to step up and buy yet, leaving a vacuum of buyers that produced an exhaustion gap in the last week of April before lower prices, as might be expected, attracted the buying necessary to form the bottom.

The "island reversal" results from a couple of gaps and is one of the more obvious chart patterns because it stands out by itself. It's like the "I dare you to step across this line" game you might have played as a child. When you do cross a line, you look around to find no one else there with you, so you decide you better get back to where everyone else is. Island reversals may take one bar or several bars and can be a strong reversal signal if the second gap is not filled within a few bars.

Next article: Retracements

Previous article: One-Bar Patterns