From the September 01, 2008 issue of Futures Magazine • Subscribe!

Precision patterns

While traditional price patterns are highly subjective, some related methods that fall under the broad umbrella of chart analysis are more exact. These are gaps, which are sudden jumps in price, which are extremely short-term relationships between opens, highs, lows and closes.

Gaps are simply areas on the price chart where there’s space between the previous trading session’s high and the current trading session’s low. Here are the four types of gaps:

• Breakaway gaps: These occur during a prevailing trend, with price often continuing in that direction, sometimes at a more rapid pace. High volume is a critical component of these gaps. They also tend to mark future areas of resistance or support.

• Exhaustion gaps: These often mark the end of trends. They usually occur on relatively low volume and are followed by sideways price movement.

• Panic gaps traditionally occur on the sell side, with price either tumbling downward after the gap or working into a horizontal trading range, using the level of the gap as support.

• Common gaps: These generally develop within trading ranges. They mark no new highs or lows and come on average volume. They reinforce that not all gaps are relevant.

Gaps also come in pairs. The island reversal is made up of an exhaustion gap and a breakaway gap, separated by a few price bars. Whereas just the exhaustion gap alone indicates nothing more than a forthcoming sideways market, the island reversal indicates a new trend in the opposite direction.

Micro-patterns are not as well known as gaps, but they have grown in popularity along with trading system analysis software. Micro-patterns describe simple relationships between key prices, usually over a few price bars. They are objective and easily programmed for testing against historical data. Although these can vary with the creativity of the analyst, two popular micro-patterns provide good examples of this type of pattern. Inside days describe a two-day trading period where the low and high of the second day are inside the parameters of the first day. Likewise, an outside day describes a two-day trading period where the high and low of the second day are outside the parameters of the first day. Both inside and outside days are considered reversal patterns if they occur at a level of support of resistance.

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