From the June 2013 issue of Futures Magazine • Subscribe!

Inside the numbers: Using gaps to interpret market direction

Common gaps are the last type of gap we’ll mention. These generally occur in illiquid trading instruments. They are just a gap that means nothing in a technical analysis sense.

Filling the gap

A common saying in investing is “gaps were made to be filled.” While this is not always true, in time many gaps indeed are filled. This simply means that price returns to the area of the gap on subsequent bars to trade within the price range of the gap. 

One example from recent price action occurred in the euro 60-minute chart (see “Mind the gap,” below). The market gapped down to 1.29 on March 18 because of the Cyprus crisis. By March 25, however, the euro had rallied following the approval of the bailout. The euro traded within the price range of the large gap down before it subsequently broke lower again. An astute trader might have kept this gap in mind while keeping an eye on political developments, identifying the upper end of the gap’s range as a likely target for an upward swing.

When provisional gaps are filled within the same trading day on which they occur, this is referred to as fading, which can be used by intraday traders as a trade signal. The logic behind fading is that once the financial instrument starts the gap-filling process, it rarely will stop because there is often no immediate support or resistance within the gap’s range. 

This happened on a 15-minute chart for the Nifty 50 — an index of the top 50 stocks on India’s National Stock Exchange — on March 25. The Nifty opened with a gap higher at 5708 due to positive global cues. It made a high of 5717 in early trading and then fell into a consolidation pattern. Astute traders would anticipate the gap open to be filled and use the 15-minute high of 5717 as a stop loss, shorting the market with the target of 5650 (the previous day’s close). The target was eventually achieved as the Nifty filled the gap to complete the fading process.

Gap trading strategies rely on context-specific criteria to enter and exit. It is an uncomplicated approach if properly employed and offers opportunities for quick profits. While you will not capture either the top or bottom of a stock’s price range on a particular move, you will be able to profit in a structured manner and minimize losses. Stops are recommended, as well as confirmation from complementary technical tools, such as pivot analysis and oscillators.

Bramesh Bhandari writes at www.brameshtechanalysis.com and provides online tutoring on technical analysis. He can be reached via email at bhandaribrahmesh@gmail.com.

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