GAPS FROM A JAPANESE CANDLESTICK VIEWPOINT

In the last two issues of this newsletter we have explored the perspective of Western technical analysis on gaps. As we have seen, the swing trader should be able to identify four different types of gaps: area (common), breakaway, continuation (measuring) and exhaustion.

As you'll remember, an "area" gap occurs within a trading pattern such as a triangle, rectangle or rounding base. Typically, the "area" gap is of little significance. Since area gaps are often filled quickly, they conform to traditional wisdom that gaps are filled.

A "breakaway" gap is an entirely different matter. The "breakaway" gap ends a consolidation pattern and happens as prices break out. Often, a "breakaway" gap occurs on very large volume, as the supply available within the consolidation pattern has been consumed and bidders who want to enter the stock must pay up for it. A genuine "breakaway" gap will often not be filled for weeks or months (if ever).

A "continuation" gap occurs within a rapid straight-up movement. This type of gap is also known as a "measuring" gap because it usually occurs approximately halfway through the move. "Continuation" gaps may eventually be filled, but it should take some time to do so as the stock needs to first peak, reverse, and finally trend in the opposite direction.

An "exhaustion" gap occurs at the end of a price move. If there have been two or more gaps before it, then this kind of gap should be regarded very skeptically. A genuine "exhaustion" gap is filled within a few days to a week.

When a swing trader sees a gap, he or she should immediately ask, "What kind of gap am I witnessing?" Often it will take some time to come to a final conclusion. What seems to be a breakaway gap, for example, may over the next several weeks be filled and that filling may be an important catalyst to take swing-trading action in the opposite direction.

Candlestick theory, while less detailed about gaps, provides some important additional insights. Japanese theory does not distinguish between the types of gaps. Nor does it even use this term. Instead a gap is called a "window."

Whereas a great deal of emphasis in candlesticks is given to reversal patterns, a window is considered a continuation pattern. In other words, trading is highly probable to continue in the same direction after the window as it did before it.

In his groundbreaking work on candlesticks, author Steve Nison advises traders that they should typically trade "in the direction of the window." If a particular stock is declining when the window" occurs, then it is highly probable that the decline will continue. If the stock is rising when the window occurs, then it should continue to rally.

Once a window has occurred, it becomes an important support and resistance area. If the window occurred in a downtrend, then on any subsequent rally the upper end of the window should turn back prices. If the window was created in an uptrend, then when prices rally the bottom edge of the window should be the lowest point of decline. Further candle theory holds that the test of all open windows is likely. The key thing to examine is what happens on this test.

In a downtrend, the opposite is true. After the initial window, the decline should continue. Eventually resistance, which is at the upper edge of the window, should be tested. If buying pressure persists and is able to move prices beyond this upper window, then the swing trader should go long in the same way they would if a resistance level were overcome.

Continental Airlines (CAL) is a stock I've spotlighted recently in our "STOCKS TO WATCH" section of the StreetAuthority Swing Trader. Its chart provides a very interesting study of gaps from the perspective of both gaps and windows.

Late in 2000, CAL peaked at almost $60 a share. It then began a steady and near uninterrupted decline into September 2002, when it hit a low near $4. In the daily chart below, we see a second test of this bottom in mid-March at $4.16.

I have labeled three "gaps" or "windows" on this chart. The first gap occurred at the very beginning of April. It ended the brief downtrend that occurred when the shares hit a peak outside the Bollinger band at $6.85 in mid-March and thus far has not been filled. Traders who followed the candlestick dictum to "go in the direction of the window" were amply rewarded here, as prices peaked five trading days later at $7.06.

A second gap or window occurs in late April. I have labeled this gap "G2," and it appears to be a "continuation" or "measuring" gap. Prior to G2, CAL had moved from a low near $4 a share to approximately $8 a share. This gap then created a target of $12 a share for Continental. The stock then reached an early May peak at $12.25.

The third gap took place at the psychologically important $10 level. What is fascinating here is that the gap could turn out to be either a "breakaway" gap or an "exhaustion" gap. Only time will tell. From the "breakaway" gap perspective, CAL shot through key resistance at $10 and did so on very heavy volume, which is typically associated with this kind of gap.

However, this gap is also the third gap in this move, which may mark it is an exhaustion gap. In market trading on Tuesday, May 5th, the gap was filled or the window was closed. Selling pressure, however, did not persist. Instead, the shares bounced off support (but on light volume). That created a short-term buy signal, although I suspect strongly that the rally will fail at $12.

Similar mixed signals are given in the balance of the chart. The stock is above rising 20- and 30-day moving averages, but below declining four- and nine-day moving averages. MACD is on a sell signal, but the histogram has hit a support level and seems to be bottoming. Daily stochastics is very near oversold but has not created a buy signal. RSI, thus far, is holding the important 50 level.

A downside level to watch extremely closely is $9.80 (if the stock tests this level again). A break of $9.80 would take out a key support level. The next support level would be the window just below $8, and that decline would bring a very high-percentage return to the alert swing trader. I will be watching CAL carefully and readers might want to follow the stock as well.

Combining western wisdom and eastern insight on gaps, what then are some key trading tactics you can take away from today's lesson? The principles below should be applied within the context of other chart messages such as moving averages, trendlines and MACD. That said, here are several swing trading principles based on gaps:

1. On spotting a gap in a daily chart, immediately question yourself as to which of the four kinds of gaps it is.
2. Generally, short-term trades should be in the direction of the gap. The larger the gap and the stronger the volume, the more likely it is prices will continue to trend in that direction.
3. If an "area" gap is identified, then the swing trader should look for a short-term peak. When prices begin to move back toward the gap, a trade may be placed anticipating the gap will be filled.
4. Upon identifying a "continuation" gap, the swing trader should, other factors considered, buy quickly. The trader should then use the measuring principle, which applies to this gap, to identify the short-term target.
5. A "breakaway" gap also provides an immediate buy point, particularly when it is confirmed by heavy volume.
6. The third upside gap raises the possibility an "exhaustion" gap has occurred. Swing traders should look for the gap to be filled in approximately one trading week. If the gap or window is filled and selling pressure persists, then that issue should be shorted. If the gap is the third one to the downside, then traders should be alert for a buy signal.

As powerful an analytical tool as gaps are, generally they should not be acted on in isolation. View the gap within the context of the other technical messages given by the chart. For a complete system of gap analysis, swing traders should apply both western and eastern concepts of gap analysis. Hopefully, this series on gaps has filled in some "holes" in your knowledge of how to apply this vital technical analysis concept.

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