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

Gartley’s gap theory explained

While they are among the simplest technical conditions, price gaps — when successive price bars fail to overlap — generate a lot of questions among traders. Why do gaps happen? How can we foresee gaps? Do gaps always get filled?

Gaps also are one of the most confounding occurrences. Often traders will follow a commodity or stock and in the course of their due diligence, the price gaps higher or lower. If price gaps in the direction they had hoped to take the trade, they may be understandably disappointed in missing the move. Gartley’s gap theory is one way to keep this type of condition in perspective.

Gaps are technical phenomena that may or may not mean anything. Some markets by their nature are predisposed to gapping, while others rarely display gaps. Once you understand the common gaps and what they mean, you can profit by correctly assessing them.

WHY GAPS HAPPEN

In its basic form, a gap is when the current bar opens above the high or below the low of the previous bar. On a price chart, a space appears between the bars indicating the gap.

Price gaps both to the upside and downside, and it can happen in any time frame. Gaps commonly appear on daily price charts, but they also are present on minute, hourly and tick charts, as well as longer-term charts such as weekly charts.

Because markets are a function of human emotion, any significant news that relates to the sector, industry, index or individual stock or commodity can result in a price gap. Stocks regularly gap on earnings announcements, merger and acquisition news and on managerial shake-ups. However, some products gap by their nature. For example, markets with low trading volume are susceptible to gapping. Before you begin trading any instrument, you should take the time to understand its tendency to gap.

Gaps are frequently accompanied by an increase in volume. Thus, interest in buying or selling accumulates and pushes price significantly in one direction or the other. Gaps also will occur in conjunction with other technical chart patterns such as triangles and wedges. Like most other aspects of technical analysis, the use of several tools is often needed to fully evaluate the technical activity.

Two large gaps occurred on the mini Dow futures contract during January 2008 when news broke of a rogue futures trader who took the French bank Société Générale for just over $7 billion. Making matters more interesting was that the U.S. markets were closed for the Martin Luther King Jr. holiday at the time of the disclosure. The mini Dow futures gapped down 491 points on Jan. 22 and another 251 points the next day. Needless to say, this intensified the bear move that was in progress from the beginning of the year and fueled the fire for commentary regarding the coming bear market. Both gaps were quickly filled.

TO FILL OR NOT TO FILL

After a gap occurs, a common occurrence is for the gap to get filled. This refers to price retracing back to the previous price action. Price does not have to stay within the gap range and close inside of it. Rather, it only needs to trade through the gap. Those using candlestick charts frequently see the tails of the candle filling the gap instead of the candle body.

Most gaps do get filled at some point in time. However, there are exceptions. Numerous gaps are still in need of filling from some of the high-flying stocks in play at the turn of the century when the dot-com boom went bust. In fact, the Nasdaq 100 index has an open 105-point gap dating back to Feb. 15-16, 2001 (see “Still open”).

GAP TYPES

Gaps are named in relation to where they occur within the chart pattern. In order of their typical appearance on a chart, there is the breakaway gap, the measuring gap (also referred to as the midway, runaway or continuation gap), and the exhaustion gap (see “Gap succession”).

Frequently seen at reversal points, breakaway gaps serve as an indication that price action is ready to change course in the opposite direction. Without doubt, these gaps are the easiest to identify and correctly classify because they generally appear at tops and bottoms of reversal patterns.

Breakaway gaps are usually among the last gaps to get filled because they are at the start of a move and nearly 100% retrenchment will be necessary to fill the gap properly. H.M. Gartley states in his book, “Profits in the Stock Market” (1935, Lambert-Gann Publishing): “If a breakaway gap is covered in several days by a rally or decline which halts short of the previous minor bottom or top, another gap in the same area may be expected.” Gartley’s point is that if a breakaway gap gets filled shortly after appearing and the previous top or bottom is not taken out, then expect to see another gap in the same general area. This action indicates that the previous trend has reversed.

Exhaustion gaps also are easily recognizable because they occur at the end of a major move up or down. As the name suggests, this type of gap appears because the market forces responsible for driving price are tired. Or, as Gartley relates it to human emotion, “…when the ‘error of optimism’ or the ‘error of pessimism’ has reached an extreme point.” As such, we can expect to see price begin to form the next topping or bottoming pattern.

The presence of an exhaustion gap does not mean price will immediately reverse, however. Rather, it implies that the move is running out of gas. Higher highs or lower lows can easily be made, but the gap is telling you that the end is near. Savvy investors and traders will heed the warning of the exhaustion gap by either adjusting their stops or position size or exiting the position all together.

Without doubt, measuring gaps are the most difficult to spot. However, they are the most important of the three gaps when it comes to projecting the termination of an impulse move. As the names “measuring” and “midway” indicate, these gaps can be used to measure the move, and they appear in proximity to the mid-point of what will become the entire move.

According to Gartley, measuring gaps appear in one of two ways. The most difficult appearance happens when price is trending diagonally and there is either an explosive directional move that causes a gap, or the move is steadily persistent and a gap appears over the course of the move.

There is really no clue as to when the move will happen. It just happens. Volume increases or spikes may accompany these moves, but because price is trending, the differentiation in volume may be hard to pick out.

The second, and easiest, method of identifying the measuring gap is when the gap occurs after a brief consolidation in price. Consolidations happen naturally as the market expands and contracts. Elliott Wave patterns or other technical chart patterns, such as triangles and flat stalls, provide key insight as to when to expect the appearance of a gap.

Price does not have to gap after a consolidation, but when it does, the technical student has an excellent piece of information on which to build.

SEEING THE END

According to Gartley’s research, the measuring, or midway, gap will appear at approximately the 40% level of the entire move. By knowing where this level is in relation to the full move, we can calculate the point where we expect the move to reach fulfillment.

The formula behind this calculation is simple arithmetic and requires both the breakaway and measuring gaps to be in place. For an uptrending move, Gartley’s formula is as follows:

E = ((L-B)/4)(10) + B

Take the low price of the second bar of the measuring gap (L) and subtract that price from the base price that preceded the breakaway gap (B). Divide the difference by four to determine 10% of the advance. Next, multiply the quotient by 10 to find the 100% value of the move. Add this number to the base of the breakaway gap (B) to determine the estimated endpoint for this move (E).

For a down-trending move, the specific formula is:

E = B- ((B-H)/4)(10)

Take the high price of the second bar of the measuring gap (H) and subtract that price from the base price that preceded the breakaway gap (B). Divide the difference by four to determine 10% of the decline. Next, multiply the quotient by 10 to find the 100% value of the move. Subtract this number from the base of the breakaway gap (B) to locate the estimated endpoint for this move (E).

Alternatively, you can multiply the differences in the gap by 2.5 and then calculate the base into the equations. Don’t get too hung up on this, though. Common Fibonacci charting tools, available in most basic software packages, will take the thinking out of it and expedite the time consumed by doing the math. The important part is to know that there is a mathematical basis driving this projection and to develop trust in the method.

Using the Fibonacci price retracement lines in TradeStation, for example, Fibs are pulled between the gap points and the base, from high to low in an uptrending move, and from low to high in a downtrend. Next, select the 250% value for the extension line to complete the formula. The resultant line is the general area where the current trend is expected to complete (see “Measuring the move”).

Another key element of this method is to know the constraints Gartley found. In particular, “we know by experience, in dealing with stock price trends, that any purely mathematical estimate is but merely a general approximation.” Further, Gartley determined that the trend will frequently exceed the estimates by several points. What this means, and what empirical data seem to confirm, is more often than not the calculations and Fib extension lines will come up short in comparison to the actual reversal point.

Historical observations reflect the difference between the Gartley projection and the actual reversal point as not being overly significant. If your trading philosophy is one of optimum, not maximum, and you took a good portion of the ride and are profitable on the trade, leaving a few dollars on the table by exiting the trade when the target is achieved may be prudent.

While this method may be usable as a standalone approach, that’s not necessary. Using multiple sources to confirm projections to the right side of the chart, such as Elliott Wave theory, Fibonacci extensions, Carney’s harmonic principles, and multiple time frames, in conjunction with Gartley’s gap theory will give you higher probabilities and more confidence in your target zone.

Gartley’s gap theory is as relevant today as it was in the 1930s. The price projection capability is a powerful asset for any trader or investor regardless of the market. Gartley’s gap theory is an important asset in locating turning points, and it should be in every trader’s toolbox regardless of the product traded.

Steve Bobbitt is a private trader and trading educator. He holds degrees in finance and an MBA from the University of Phoenix. Contact him at trail8llc@gmail.com.

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