Morning gaps drive traders crazy, because they hurl positions and assumptions into unknown territory. These shocking events also force an immediate re-evaluation of the charting landscape to deal with the altered reward-risk equation. But the extra work pays off, because the gaps may predict big changes in subsequent price action.
Gaps reveal shifts in crowd sentiment through single price bars. They can print anywhere within a pattern or trend, but they tend to occur in several common scenarios. Each type of gap generates unique characteristics related to persistence, response during retracements and impact on price movement.
Gaps cut through all time frames and trends, but they represent different phenomena in each one. For example, a breakout move in one time frame may print an exhaustion event in another.
A gap's importance is directly related to its location, range and volume. For this reason, a high-volume gap late in a trend often signals the end of the move.
A gap can print in the direction of the major trend, or against it. When it moves against current momentum, it triggers the only chart phenomenon that can signal trend change without a topping or bottoming pattern. A narrow-range or wide-range bar can stand at the end of the gap event. Long bars predict reliable follow-through in the direction of the gap. Short bars suggest sideways action, or a pullback into the violated space.
Take the time to distinguish between gaps in the direction of the trend and those moving against it. Countertrend gaps represent important shock events when they occur near big highs or lows. For example, a price break in the wrong direction after a strong rally can produce considerable fear and lead to much lower prices.
Gaps through major support and resistance levels signal breakouts and breakdowns. Emotions can build so strongly at these levels that the gap exceeds common sense and sets off a violent reversal. Strong greed or fear can trigger multiple gaps as a growing trend builds momentum. Gaps that print within sideways patterns show less persistence and can fill with little warning or volume.
Gap creation aligns with Elliott Wave Theory. The breakaway gap corresponds with the breakout that occurs during the dynamic first-wave impulse. Runaway emotions trigger the continuation gap at the center of the third-wave rally or selloff. The trend sequence ends with the fifth-wave exhaustion gap.
The continuation gap should mark the halfway point of a trend. Traders familiar with waves can use this projection to target potential reversal levels. Visualize the gap as soon as possible after the fourth wave begins. Then draw an extension from the edge of the first wave into the continuation gap. Then double that distance and wait for price to push into the target level. Enter a position in the opposite direction when price moves out of a reversal pattern in a smaller time dimension.
High-percentage gaps can exhaust further movement in that direction for an extended period of time. The reason is simple: The big move forces all uncommitted players off the sidelines, while winners take profits and losers take losses. This provokes an overextended condition that forces a reversal back toward the prior bar.
Opening gaps fascinate traders but require solid execution skills. Cash seeks opportunity at the start of the day while insiders paint the tape to encourage execution. This encourages a supply-demand imbalance, with ill-advised orders well above or below the market, depending on the gap direction. The resulting friction can set the stage for a reversal just minutes into the new session.
No easy formula shows traders how far a gap can travel and still remain healthy. But we need to apply common sense when observing premarket action above or below the last closing price. The most important question for traders to consider: Does the news and market environment justify the price you're seeing?
The level of crowd participation limits or fuels the strength and durability of the gap event. Certain gaps verify only when strong volume accompanies them. For example, a breakaway gap without heavy volume suggests it will eventually yield to a failed breakout.
The relationship between gaps and the crowd relies on complex interactions. For example, a high-volume gap may end movement in that direction because it uses up the last available supply for that trend. But another gap with less volume leaves just enough on the table to ensure sustained movement in that direction.
Old traders' wisdom tells us that gaps get filled. This classic expression does a good job describing the mechanics of retracement found in most trends. However, some gaps never fill. This suggests using common sense with these specialized patterns. Learn the unique characteristics of each gap type and then apply the strategy that aligns best with its behavior.
Source:www.hardrightedge.com
