S5_Fundamental of Technical Analysis and Algorithmic Trading

8/13/2019 S5_Fundamental of Technical Analysis and Algorithmic Trading

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Saeed Ebrahimijam

Spring 2012-2013

Faculty of Business and EconomicsDepartment of Banking and Financeu kdeniz niversitesi

FINA417


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Frequency of appearance Insignificant Gap Significant Gap Common Gap Breakaway Gap Runaway Gap Exhaustion Gap The Island Reversal The Total Picture A wall-street Myth-Gaps must be closed

2Fundamental of Technical Analysis and Algorithmic Trading


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Gaps occur more frequently on charts covering short time frames(such as hourly or daily) than they do on longer-term charts(such as those plotting weekly or monthly data). However, theyare of greater significance on long-term charts than on short-term charts. The reason for that is easily explained.

Gaps are common on daily charts because they can be createdon a daily basis (20 or more times during a month). At the end ofeach day, an opportunity exists that the current days high (orlow) price will be lower than (or higher than) any price at whichthat stock trades on the next day.

However, on a monthly chart, only one opportunity each monthexists for a gap to occur. It is rare, and thus of greatsignificance, that the high (or low) price for the current monthwill not be crossed at some time during the next month andcreate a gap.

Gaps occur on monthly charts is when a panic rise or declineoccurs at the end of the month.

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Some gaps are significant, while others aremeaningless. Gaps that are not significant include:

1. A gap caused by a stock trading at an amount equalto the minimum permitted change in price.

2. For higher-priced stocks, the spread betweensuccessive bids is frequently $0.10 to $0.50. Gaps

equal to the normal interval between successive bidsare of no technical significance.

3. For medium- to high-priced issues that have lowtrading volume, gaps are regular and numerous. Theyare also not significant.

4. Ex-dividend gaps frequently occur when a companypays a dividend. The stock usually drops in price bythe amount of the expected dividend. Ex-dividendgaps are actually an alteration to the book value of anissue and have no trend implications.



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The common gap is the least important of thesignificant gaps. It normally occurs in thinlytraded markets or within a trading area orprice congestion pattern.

It often merely reflects a lack of tradinginterest.



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Typical Price ActionA stock moves in a certain pricerange, say $15 to $25 per share. A gap is thencreated by a jump from $22 to $25. It is likely thatcongestion will be formed between $22 and $25.

Typical Volume Action Volume is relatively lowresulting from being in a congestion pattern $22 and$25. Highamount of demand creates buying queue

Frequency of Occurrence Common gaps occur oftenas the name commonsuggests.

Technical Significance are of little forecastingsignificance. However, they can alert technicians to acongestion pattern that is in the process ofdeveloping



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Most breakouts from a horizontal priceboundary are attended by a breakaway gap.



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Typical Price Action A breakaway gap occurs on a pricebreakout through a horizontal pattern boundary. Typically,the horizontal pattern boundary is part of a pricecongestion pattern (such as an ascending triangle), andthe breakout marks its completion.

For example, suppose a stock has traded up to 21 pershare, stopped, and turned lower over and over. Thiswould suggest both a persistent demand for and a largesupply of stock available for sale at the $21 level. Currentstockholders observe the price action and make their stockavailable at the $21 level or figure that once the stockbreaks the $21 barrier, it will go much higher.

This creates a vacuum so that once the supply of stock at$21 is absorbed, the next buyer finds none available at21.01 to 21.49. He or she must bid 21.50 and thuscreate a breakaway gap.



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Typical Volume Action, Volume is normallyheavy when a breakaway gap occurs. Ifvolume is higher before the gap than after,chances are about 5050 that the gap will be

filled on the next minor reaction. If volume ishigher after the gap than before, chances areslim that near-term reactions will fill the gap.



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Frequency of OccurrenceBreakaway gaps appearmuch less frequently than common gaps do, butthey appear often enough to warrant watchingfor them.

Technical Significance Breakaway gaps are highlysignificant. They often signal the start of a rapidprice move in the direction of the breakout. Anupward move is caused by buying demand that isstronger than selling pressure, often resulting in

prices moving up quickly until balance is restoredbetween supply and demand. The opposite istrue for down movements.



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In brief,find the Break out Gaps to set as real breakout point in the patterns.



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The runaway gap is a reliable indicator of astrong underlying trend. It is sometimescalled a continuation or measuring gap.



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Typical Price Action Runaway gaps occur in themiddle of fast up or down price movements. Thisis typically when price quotes are moving rapidlyand easily relative to the volume of transactions.

Typical Volume Action Runaway gaps typicallyoccur on moderate volume when the prices areseemingly moving effortlessly. At times, runaway

gaps are accompanied by relatively high volume,which increases the probability of a strongunderlying trend in the direction of the move.



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Frequency of Occurrence Runaway gaps occur less often thancommon or breakaway gaps, but they are more significant from atechnical perspective.

Technical Significance Runaway gaps are a sign of significantstrength in an uptrend or weakness in a downtrend.

- They are easy to distinguish from common or breakaway gaps.

- Distinguishing a runaway gap from an exhaustion gap is not easyinitially. However, the price and volume actionon the day afterthe gap provides the evidence you need for a correctinterpretation.- Runaway gaps usually are not filled until the next intermediate or

major price move. This typically occurs only after a considerableamount of time has passed.

- Multiple runaway gaps can occur. When two or more such gapsoccur, the measuring implications are less certain. One shouldact conservatively in these situations, recognizing that eachadditional runaway gap brings a price top or bottom nearer.(near to the end of the Trend)



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An exhaustion gap is the last gasp of an upor down price move. It is very difficult todistinguish from a runaway gap until after thefact.



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Typical Price Movement An exhaustion gap isassociated with a quick up or down movement inprice (like a runaway gap). Prices move rapidlyuntil, suddenly, they meet an abundance ofsupply in an up move or demand in a down

move. At that point, the move is ended abruptlyby a day of very high trading volume. It is notuncommon for an exhaustion gap to appearbetween the next to the last and the last day of amove.

Typical Volume Activity An exhaustion gap isusually accompanied by a day of very highvolume on a relative basis.



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Use STOP LOSSorder, close to gap price when you faced aexhaustion gap because of probable changing.



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Occasionally, a section of a chart is isolatedfrom the rest of the chart by gaps appearingat approximately the same horizontal pricelevel. When this pattern occurs, it is known asan island reversal.

Typically, the gap leading to the islandreversal is an exhaustion gap, and the gapcompleting the island reversal pattern is abreakaway gap.



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An island reversal can represent one or moreperiods of trading activity. It can also be part ofanother chart pattern (such as the head of ahead-and-shoulders pattern). It is characterizedby relatively high volume.

By itself, an island reversal does not suggest thata long-term top or bottom has occurred.However, prices do frequently retrace the minormove that preceded it. Much of that retracement

is accomplished by the time an island reversal ischarted, thereby minimizing the value of anytrading opportunity.



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When a gap occurs on a price chart, it is not uncommon to

read or hear someone say that the price must come backand fill the gap that was created. Over time, the probabilityis that the gap will be filled, since most securities trade incertain price ranges.

However, there is absolutely no reason why it must beclosed. And, frequently, when it is closed, it is only after

the price has moved far away from the gap.

For example, over a period of time, a stock moves in arange from $9 to $15 per share. One day it closes at thetop of the range. The next day it opens at $15.50 andcontinues to move up from there, causing a gap to occur.

The price subsequently climbs to $25 before retreatingback through $15, thus closing the gap. The gap is closed,but only after a period of time (which could be months oryears). Basing an investment decision on gaps must beclosedis not sound investing.

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