From the June 2013 issue of Futures Magazine • Subscribe!

Inside the numbers: Using gaps to interpret market direction

Continuation gaps occur during the ongoing trend, and signal a rush of buyers or sellers who share a common belief in the underlying stock’s current direction. After identifying a continuation gap, traders should enter in the direction of the current trend or consider adding to existing positions. A stop loss should be placed at the low (in the case of a long trade) of the day of the gap. A trailing stop loss should be maintained as price moves in the trader’s favor.

There’s a good example of the continuation gap in the SPDR Financial exchange-traded fund (XLF). As seen in “Gap and go” (below), XLF began its uptrend move with a breakaway gap in January 2013. It then formed a continuation gap on March 5, when the fund opened at 17.90 vs. the previous trading day’s close of 17.79. Because the gap occurred in the direction of the existing trend, it qualified as a continuation gap. As such, a trader should have gone long XLF with a stop loss at 17.90 and a profit target of 4%-5%. In this case, tight risk control would be prudent because the signal comes in the wake of a significant move higher. 

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