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EXHAUSTION AND RUNAWAY GAPS In our previous "Inside The Black Box" section we contrasted two types of gaps -- the "common" or "area" gap and the "breakaway" gap. Common gaps, as you will remember, occur within fixed patterns such as rectangles or triangles. They typically have little trading significance. These are the types of gaps that conform to conventional wisdom about gaps -- "gaps are always filled." In contrast to the "common" gap is the "breakaway" gap. "Breakaway" gaps typically end consolidation patterns such as rectangles, triangles or bases. They often occur on very high volume, signaling that supply at a fixed level has been exhausted and that purchasers anxious to acquire the stock must pay up to do so. Genuine "breakaway" gaps are typically not filled for long periods of time (months, years), if at all. When a gap occurs, I argued, it is important to ask yourself what type of gap it is. Time is often necessary to judge the gap accurately. If prices after a "breakaway" gap retreat, but then hold above the gap and take out the high, then you probably have a genuine "breakaway" gap. A third type of gap that can be profitable for swing traders to recognize is called the "continuation" or "measuring" gap. This type of gap often occurs in rapid advances. The "continuation" gap has a clear measuring principle. The gap often occurs approximately halfway through an advance, so that prices will often advance beyond the gap approximately as much as they went up before it. I've presented you with a historical chart of Roadway Express (ROAD) below, as it provides an excellent example of a "measuring" gap. From a low just below $30 in early March, the shares exploded in a near-vertical advance to a high of $36.85 just eight trading days later. Profit taking then set in and ROAD retreated to a low of $33.25. The formation appears to be a Flag, (a topic for another installment of Inside The Black Box).
The gap that ended the brief retracement can be interpreted as a "measuring" gap. The prior move had been from $29 to approximately $33.25. A gap (labeled G1) then took place at approximately the $34 level, which means that a gain of $5 had already been made. The target thus projected was $39. Sure enough, a few weeks later ROAD hit a peak of $39.91. The chart of ROAD also is interesting to analyze from the point of view of "exhaustion" gaps. As the name implies, an "exhaustion" gap occurs at the end of a move. It is the last fevered push of the bulls. The alert swing trader can often recognize an "exhaustion" gap by the fact that on the following day there is little or no further upward movement. Moreover, volume often peaks on the very day of the exhaustion gap or the day after. The more gaps you see in any given chart, the more skeptically you should regard subsequent gaps. My rule of thumb is three. If a given chart shows two previous gaps in recent weeks, then look for possible evidence that the third gap will be of the "exhaustion" variety. "Exhaustion gaps" are typically closed in one trading week or less. When the "exhaustion" gap is closed, it is likely that the trend has peaked. Back to the ROAD story. After the first "continuation" or "measuring" gap, the stock consolidated near $35 for three trading days. A second gap (G2) then occurred, which led to a test of resistance at about $37. ROAD subsequently retreated, finding support at around $36. Then the third gap, marked G3, took place. Note that it was on very high volume and took the stock into important resistance at just under $40 a share. The next three candles were negative and filled the gap, illustrating the principle that an "exhaustion" gap is typically closed within one trading week. Again, the stock found support at $36, tested $40 and failed on declining momentum. With a close just above $35, negative MACD and a rapidly dropping stochastics, further retracement seems likely from here. While it is probably too late for a highly profitable swing trade, day traders might want to watch this stock early the week of May 19th for further weakness. (I have picked up another major trucking company, JBHT, as a short sale in this week's newsletter -- see article #5 above.) Although last week I mentioned that I would cover the Japanese perspective on gaps in today's issue, I am going to deviate from that plan slightly and will discuss that topic next week. Instead, while I am on gaps, I want to talk about the fairly rare "island reversal." The "island reversal" consists of two gaps -- one upside and the second downside -- that are made in very rapid succession. As a result, a little "island" is left with no trading around it. This pattern is unusual because the market is, in essence, totally reversing its viewpoint on the stock. The first gap is highly bearish. The second highly bullish. While the island reversal sounds like a very important event, in actuality the second gap usually just produces a reversal of the previous movement. In other words, the stock, if it is a "bullish island reversal," is likely to retrace to approximately where it was when the downturn started. The stock I have selected as an example of a bullish island reversal is Clear Channel Communications (CCU). As veteran readers of the StreetAuthority Swing Trader know, this stock has been on my watch list of stocks to short for quite some time.
The "island reversal" that occurred in the $33 range suggested the shares should retrace to about $39 or $40. In fact, they have already made it to a high of $41. There is strong resistance right around $40 and the shares are now showing deteriorating momentum. I have drawn two uptrend lines on the chart and also a trendline above the recent highs. This analysis suggests the stock is in a rising wedge formation -- typically a bearish pattern. A break of the steeper rising trendline would occur at approximately $38.50. Swing traders following CCU should write that price down or plant it firmly in their memory. A breach of $38.50 should lead to a good short trade.
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