From the June 2013 issue of Futures Magazine • Subscribe!

Inside the numbers: Using gaps to interpret market direction

Gap classification

Gaps can be placed into four different groups.

Breakaway or breakout gaps occur in the beginning of the trend. These give trader an indication that a new trend is emerging. This is the most potentially profitable gap for trading purposes. Breakaway gaps may not get filled on subsequent trading days, and even if they do it takes a long time for price to return to the area of the gap. After identifying the breakaway gaps, a trader should go long or short in the stock with a stop loss at the low of the day of the gap. Maintain a trailing stop loss once price moves in the position’s favor.

Consider an example found in India’s Sensex, a value-weighted index based on 30 of India’s largest stocks. As seen in “Break and run” (below), Sensex formed a breakaway gap on May 18, 2009, when the market opened at 13,479. The previous trading day, May 15, closed at 12,173. This massive gap occurred after an election that the market considered economically favorable and, with the foundation of those fundamental underpinnings, it was a clear indication that a new trend was starting. In such a scenario, traders were well-advised to go long Sensex with a stop loss of 13,479 and a target of 8% to 10%.

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