GAPS

Several of the trades I have recommended in the StreetAuthority Swing Trader involve the analysis of gaps. A gap is a "hole" in the chart -- a space or a vacuum that is empty, at least temporarily, of price action. When I teach seminars I find that traders are often very confused about gaps and generally assess them too mechanically.

Someone will usually make the point that "all gaps are eventually filled, aren't they?" The answer to this is a resounding "No," as all gaps are not filled. The purpose of this week's installment of INSIDE THE BLACK BOX is to dispel some misconceptions about gaps. In today's issue I will write on two of the gaps associated with the western perspective on gap analysis -- the "common" gap and the "breakaway" gap. Next week, I will discuss the "runaway" gap and the "exhaustion" gap and will introduce the treatment of gaps from a Japanese candlestick perspective. Finally, in the following week I will explore the Japanese perspective in detail and will synthesize key swing trading principles by combining both western and eastern gap trading techniques. I have not encountered any technical theory attempting this synthesis in any of the volumes of books and web sites I have read.

First, what causes a hole or gap in a chart? There are several reasons why a gap might appear in the graph of an individual stock. One of the most common causes of a gap is an earnings release that is above or below Wall Street's expectations. Closely related is an upgrade or downgrade by analysts in the stock. In addition, a product announcement or other major news item will often create a gap. A major overnight move in the S&P futures can create in many individual issues a move that is not related to any specific news about the stock. Small gaps can also occur for a variety of reasons -- a stock going ex-dividend, for instance, can create a gap.

The daily chart reflects the price action of a stock within the market's normal trading hours -- 9:30 AM to 4:00 PM Eastern time. Many stocks, however, trade in the pre-opening and after-hours markets. A stock that has had an after-hours earnings announcement or an analyst upgrade will often trade at a dramatically different price from the "official" close at the end of the previous trading day (this is the figure you'll see printed in this newsletter or recorded on the Internet). When the stock opens in normal hours the next morning, this price movement will be reflected on the chart.

An up gap is created on the daily chart when the high of day one is lower than the low of day two. A down gap is created when the low of day one is higher than the high of day two. The larger the gap, the more significant is the message about supply and demand. A downside price gap of several dollars, particularly when it is associated with high volume, reflects urgent selling. An upside price gap of several dollars, particularly when it is associated with high volume, represents urgent buying. This sense of urgency is seldom played out in a single trading session.

Western technical analysis distinguishes four main types of gaps. These kinds are the "common" or "area" gap, the "breakaway" gap, the "runaway" gap and the "exhaustion" gap. As an astute swing trader, as soon as you spot a gap on a chart you should immediately ask yourself which type of gap it is.

In this week's INSIDE THE BLACK BOX I will focus on the contrast between a "common" gap and a "breakaway" gap. For both of these discussions I will use AT&T (T) as an example.

A "common" gap occurs within a specific trading range or price congestion pattern. If a stock is in a triangle or a rectangle, then one can expect these gaps to occur periodically.

The alert swing trader can use a "common" gap to spot a short-term trading opportunity. Since the stock is within a trading range, it is likely that prices will eventually trade back into the gap. These are the kinds of gaps that conform to the popular wisdom about gaps being filled. You can see an example of a very small common gap in the AT&T chart during January 2003. For better visibility, I have presented a blow-up of the time period the gap occurred.

In contrast to a "common" gap, which occurs within a price pattern, a "breakaway" gap completes a price pattern such as a rectangle or a triangle. A good example of a downside "breakaway" gap is also found in the AT&T chart.

Between November 2002 and January 2003, the stock traded in a near rectangle formation with resistance near $29 and support just above $25. With the release of fourth-quarter earnings in mid-January, the stock plummeted. Although the candle is hard to read, AT&T opened the day just over $22, declined to slightly under $20, and then rallied on the day to close just over $20. The breakaway gap interpretation was certainly reinforced by the enormous volume on that day. Whereas average daily volume had been under 10 million shares, the day of the breakaway gap saw over 50 million shares traded.

For five straight days after the gap, and 12 of the next 14 days, selling pressure persisted. Note that at no time did AT&T even come close to filling the gap between $22 and $25. Instead, it met resistance at $19, consolidated briefly, fell to $15, consolidated briefly, and then hit a low of $13.45 in mid-April.

In mid-April, the second very large gap appeared on the chart, coinciding first with a period of strength in the S&P 500 and with an above-expectations earnings release from AT&T. This time the shares traded more than three times the normal volume at about 30 million shares. Now traders are left to decide whether this gap is a "breakaway" gap that ended AT&T's steep downtrend or it is a huge "common" gap in what will ultimately be a sideways basing formation between $13.45 and just under $17.50.

The jury is still out on whether the latest gap will be a "breakaway" gap that will lead to higher prices, but everything about the chart suggests the opposite to me.

First, AT&T has hit resistance at $17.50, the previous support level. It has not been able to break through that level and has dropped back to the mid-$16 range.

The moving averages are uniformly negative. The 150-day is sloping bearishly down. The four-day is above the nine-day -- a short-term negative signal.

Momentum indicators are flashing sell signals. Stochastics has had a negative crossover after having become overbought. RSI is just about to cross the 50 line. The MACD histogram has steadily deteriorated and MACD is about to resume its downtrend. The stock very briefly outperformed the S&P, but is now slightly underperforming that index.

A key level of analysis for AT&T is the top of the gap, which is at about $15.70. Any trade below that level is likely to lead to a rapid price decline, as it is likely stop losses will be triggered at that point. If my interpretation is correct and this gap is an unusually large gap within a trading range, then it should be filled. That creates a target of around $13.50, the top of the gap. Shorted at say $16, AT&T would provide approximately a +16% return if it filled that gap -- enough to fill a hole in any pocket.

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