eline, look back at Figure 15.2. Five days after the stock reaches a new high anda flag begins forming, the stock spikes upward. Then, just as quickly, prices
turn down again. It is over a month before prices rise above the highest highand a lot can happen in a month! Better yet, look back at Figure 15.4 and lookat the false breakout. If you had taken a position in the stock when pricespierced the trendline, you would have ended with a loss. This trading tacticwould have prevented you from investing in the stock.
After you take a position in the stock, hang on for the ride. The rise usually will not be a straight-line advance but more like a staircase. The stock rises,consolidates, then rises again. Figure 15.6 shows this behavior. In mid-September, just after the volume spike, prices retrace a bit before advancing again.Then they move up to the flag and pause. Another advance and pause bringshigher prices into December. And so on. As long as the stock is stair-steppinghigher, hang onto it.
John is nuts. I say that in a friendly, good sorta blast to be around. Always effervescent, bustocks just as he runs his life: carefree, pedaWhen he spotted the high, tight flag shtime in taking a position. When prices piercin big (above point A on the chart).He placed a stop l/s below the formatiwas stopped out."A billion here, a billion there, andmoney!" he grunted as he told me about theHe backed off for a few days and waitehigh (6l/2). When it did, he bit and piled insidered the bottom of the flag a support areastop loss. This time, however, he used a mena broker but kept in his head. There is realproviding an investor is willing to pull theWith unreliable John, that is always a problNow and again, John looked at the prwas doing. The stock climbed to a support zmonths. Toward the end of that time, he raThen, the stock climbed again. It ignorin early January and late February, and so da new high, quietly disclosing that the doublstock passed 13 in mid-April, John started13 'A and back off for a bit, sinking to a lowJohn drew a trendline upward followingpierced the line, he called his broker. He so157/8, but "close enough for government wsions, he made 108% in slightly less than 8
Tour
241
There are five types of gaps, four of which I review in this chapter. Theemaining gap, the ex-dividend gap, is not considered because it rarely happensfn d has no investment significance. The ex-dividend gap usually occurs in utility stocks or stocks with high-paying dividends. On the day of dividend distribution, the price sometimes moves downward leaving a gap in the price chart.Even though the price of the stock after distribution reduces by the dividendamount, the day's trading range often fills the gap so no actual gap appears onthe chart.I define closing the gap to be when prices return and span the gap completely. The area or common gap closes quickest, with 90% of those gaps clos-
16Gaps
ing within a week.
Listed in the Results Snapshot tables are die average days for the gap toclose. Sometimes gaps close quickly (such as exhaustion gaps) because they arefound near the ends of trends where prices reverse and fill the gap. Other gapstake much longer since they mark the start of a strong trend (breakaway gap).The continuation gap is a combination of the two because it commonlyappears in the middle of trends.
Tour
R E S U L T S SNAPSHOTAppearance
A gap appears in the price because the current low ishigher than die prior high (for uptrends) or thecurrent high is below the prior low (downtrends).
Reversal or consolidation
Short-term (up to 3 months) consolidation
Area, common, or patterngaps
90% close in 1 week. The average close time is 6 days.
UptrendsCap Type
Close within a Week(%)
Average Daysto Close
83
Breakaway
1
Continuation
11
70
Exhaustion
58
23
Close within a Week
Average Daysto Close
DowntrendsGap Type
240
Breakaway
6
86
Continuation
10
43
Exhaustion
72
17
A gap appears in an uptrend price series when yesterday's daily high is belowtoday's low price. A downtrend gap is similar, being created when yesterday'slow is above today's high. In both cases, some type of exuberance is driving thestock to create a gap. It sometimes is nothing more than the stock being worthless simply because of a dividend distribution. At other times, the repercussionsare more severe. An earnings surprise, either positive or negative, often causesa gap and the stock to rise by 10% or 15% or to decline by 30% or more,depending on the severity of the news.Figure 16.1 shows a plethora of different gap types. Area or commongaps occur in areas of congestion, usually when prices are moving sideways.They gap up or down and close quickly. Of all the gap types, area or commongaps are, well, common—appearing all over the place. Breakaway gaps appearat the start of trends. They, too, are quite numerous and accompany high vol-
ume. Usually there is some fundamental event driving the stock, creating abreakaway gap. Continuation gaps are relatively rare because they appear inthe middle of strong trends. Those trends themselves do not occur very oftenand even less often do they contain a gap. Exhaustion gaps signal the end oftrends. They are the last jump up or down before the trend either reverses ormoves sideways.
242
Caps
Table 16.Identification CharacterGap Type
Discussion
Area, common, or pattern
Occur in areas of crapidly. Volume onreturns to normal ior lows (in downtrcurl as the gap clo
Breakaway
Identifies the startbreakout from a cohigh volume on thseveral days. Thenew highs (for uptoccur after the ga
Continuation, measuring,
Happens in the mPrices continue mthe gap. Volume idirection of the tre
or runaway
Figure 16.1 Plenty of gaps appear in a daily price chart. The most numerous arethe area or common gaps.
Identification GuidelinesTable 16.1 lists identification guidelines for gaps. Area, common, or pattern gapsare all names for the same type of gap. The gap forms inside a consolidationregion. It is easy to spot as prices seem to hook around and close the gap in lessthan a week. Figure 16.2 shows many examples of this hook feature. For example, you can see in late March that prices gap down and the next day the highcloses the area gap. A quick hook such as that is characteristic of area gaps.Usually, few or no new highs (for uptrends) or lows (when prices gap lower)occur immediately after the gap.Volume may be high on the day prices gap but usually settles downquickly. You can see this in late January. The volume spikes on the gap daythen returns to normal the next day.Breakaway gaps highlight the start of a new trend. Volume rises substantially above the prior day and prices gap upward and continue rising (or fallingin the case of a descending price gap) forming new highs (or lows).Consider the breakaway gap in early January shown in Figure 16.2. You cansee prices moving up for 3 days accompanied by a rising volume trend. Thenprices level out and move horizontally for several weeks before gapping down inan area gap. Two days later, another breakaway gap (not labeled on the chart)appears and prices reach new daily highs for 3 days in a row before settling back.The large breakaway gap in mid-April, accompanied by a high volumespike, might be an exhaustion gap. Since prices soon continue rising (making
Ex-dividend
Is triggered by a dby the amount of tday's trading rang
Exhaustion
Occurs at the endnot followed by nebe unusually wide.dation region. ComThe gap closes qu
new highs), I have chosen to label it a boccurs in early June on the way down. Volularge gap. Usually large gaps are associate
continue moving lower after just a few days,
Continuation gaps occur in the middlpen often since it takes a sharp rise followedstock (the reverse for downtrends, too). In Fuation gaps in August when prices zoom froweeks. Two continuation gaps appear in thenot unusually high, volume. The quick rremains open (compare these continuationcloses). Of course, in a downtrend, prices gaExhaustion gaps commonly follow cothe August uptrend is an exhaustion gap. Atinuation gap, but the gap is slightly largerdays before making new highs. Those areexhaustion gaps. Excessively wide gaps arthey appear near the end of a trend. Two e
244
Gaps
Table 16.2Statistics for AreaDescriptionNumber of formations in 25 stocks from1991 to 1996Number of gaps closed in 1 yearAverage time to close the gapPercentage of gaps closed in 1 weekVolume for gap day and next 5 dayscompared with 25-day moving average
Note: I needed only 25 stocks to record a representa
show high volume during the gap but then vpattern often becomes an important clue to
Figure 16.2 Various gap types with area gaps illustrating the hook feature. Volume pattern and position within the trend are the main keys to identify correctlythe different gap types.
Statistics: Breakaway Gaps
Table 16.3 shows statistics for breakaway gap
breakaway gap is perhaps the most importan
one in August and one in September. The September gap closes quickly, whichis typical for exhaustion gaps.
stocks over 5 years, more than enough for agaps occur near the start of a trend, the av
Most exhaustion gaps occur on high volume; it is like the last gasp before
prices end the trend. You can see in Figure 16.2 that both exhaustion gaps havehigh volume, but the September one takes the cake. Volume spikes upwardeven as prices descend, then volume recedes but remains high for several daysafter the gap. The high volume highlights the struggle of investors who wantto purchase the stock at a good price with those who are trying to get out of thesituation at the best offer.
Statistics: Area GapsTable 16.2 shows statistics for area gaps. After 25 stocks, I stopped logging theformations since they are so numerous. I uncovered 174 in the 5-year timespan. Since these formations offer little investment interest, many performancestatistics were not collected. However, 98% of the formations have gaps thatclose within 1 year. Most of them (90%) close within a week. The average timeto close the gap is a very short 6 days.Due to the short nature of gaps, I chose to compare the volume figures
using a 25-day moving average of volume. On the day prices gap, the volumeis 135% of the average volume. The following day, and for succeeding days, itis below average. This only emphasizes the belief that many area gaps may
Table 16.3Statistics for BreakawDescription
Uptrends
Number of formations in 50stocks from 1991 to 1996
98
Average rise or decline
25%
Most likely rise or decline
10% to 20%
Days to ultimate high, low
77 days
Percentage of gaps occurringnear 12-month low (L),center (C), or high (H)
L21%, C27
Percentage gain or loss for each12-month lookback period
L26%, C31
Number of gaps closed in 1 year
74 or 76%
Average time to close the gap
83 days
Percentage of gaps closed in1 week
1%
Volume for gap day and next5 days versus 25-day movingaverage
197%, 144139%, 120
246
Statistics: Continuation Gaps
Gaps
uptrends is 25% and in downtrends 20%—both quite large for gaps. The mostlikely rise and decline is similar, about 10% to 15% or 20%, depending onwhether the gap occurs in an uptrend or downtrend. I arrive at the most likelyrise or decline by using a frequency distribution of the gains or losses. The binwith the highest frequency becomes the one with the most likely gain or loss.This method helps evaluate the skewing of the average due to a number of outsized gains or losses. The most likely gain or loss gives a more realistic performance expectation.The average number of days to the ultimate high or low is 77 and 52 daysfor up and down trends, respectively. Both periods are quite short, indicatingthat to profit from gaps, you have to act quickly.
Separating the yearly price range into three categories, high, center, andlow, provides a way to assess where most breakaway gaps occur. Most gaps happen in the upper third of the yearly price range, even for those that trend downward. When the performance overlays the yearly price range, we find that thebest performing uptrend gaps occur in the center third of the yearly price range,with gains averaging 31%. For gaps in a downtrend, those gaps occurring in thelowest third of the yearly price range perform best, with an average loss of 2 5 %.Breakaway gaps close within 1 year 76% of the time in uptrends and 66%in downtrends. The average time to close the gap is similar for breakaway gapsin up and down trends, at almost 3 months each. The number of gaps closingunderstates the actual value since some gaps occur with less than a year remaining in the study. Many of them close anyway, but a few remain open at the end
of the study, and no attempt was made to determine if they close within a year.Only 1 % (uptrend) and 6% (downtrend) of the gaps close in 1 week. Thisshould come as no surprise as breakaway gaps often start a trend. Prices moveup or down rapidly and do not look back. With average gains or losses of 25%and 20%, it takes quite a while for prices to return and close the gap—certainlymore than just a week in most cases.
You can see in Table 16.3 that the volume trend for breakaway gapsremains high throughout the week after a gap. The day on which the gapoccurs, volume essentially doubles above the average and remains high. Highvolume is a key factor in identifying breakaway gaps, so consult volume if thereis any doubt about your identification.
Statistics: Continuation GapsTable 16.4 shows statistics for continuation gaps. As gaps go, these are somewhat rare, occurring only 160 times in 100 stocks over 5 years. Perhaps themost remarkable facet of continuation gaps is that they occur near the middleof a trend. As such, their average rise is about half that of breakaway gaps, at11 % for both up and down trends (compared with a 25% and 20% for breakaway gaps, respectively).
247
Table 16.4Statistics for Continuation CapsDescription
Uptrends
Downtrends
Number of formations in 100stocks from 1991 to 1996
85
75
Average rise or decline
11%
11%
Most likely rise or decline
10%
10%
Days to trend high, low
1 4 days
11 days
Percentage of gaps occurringnear 12-month low (L),center (C), or high (H)
, C17%, H72%
L26%, C48%, H26%
Percentage gain or loss for each12-month lookback period
L10%,C6%, 1-111%
Number of gaps closed in1 yearAverage time to close the gap
74 or 87%
71 or 95%
70 days
43 days
Percentage of gaps closedin 1 weekVolume for gap day and next5 days versus 25-day movingaveragePosition of gap in time trend(trend start to gap start)Position of gap in price trend(trend start to gap center)
L12%, C11%, H10%
11%
10%
223%, 165%, 144%,143%, 135%, 133%
242%, 149%, 118%,99%, 105%, 97%
48%
58%50%
The most likely rise or decline is 10% for both up and down trends.Again, a frequency distribution of performance removes any skewing caused by
large numbers in the average.The days to the trend high or low is about 2 weeks, quite short whencompared with breakaway gaps. You might think that since continuation gapsappear in the middle of trends, they would be about half the trend distance tothe ultimate high (when compared to a breakaway gap that starts a trend).With continuation gaps, I did not search for the ultimate high or low but thetrend high or low—to prove or disprove that continuation gaps appear in the
middle of trends.Many times a short trend ends even though the overall trend is upward.In Figure 16.1, for example, the short uptrend in the middle of January ends aweek after it begins even though the upward bias of the stock carries priceshigher until mid-May. The ultimate low and high on the chart occurs in midJanuary (for the low) and mid-May for the high. The trend low and high both
occur in January.For uptrends, gaps occur in the upper third of the yearly price range,whereas for downtrends, they happen in the center third. Overlaying the
248
Trading Tactics and Sample Trade
Caps
performance figures on the frequency distribution of gaps in the yearly pricerange shows that gaps occurring in the highest third of the price range performbest with average gains of 11%. For downtrends, the best performing gapsoccur in the lowest third of the price range, scoring losses averaging 12%.Nearly all the gaps (87% and 95%) close within 1 year. Again, some gapsdo not have a chance to close before the end of the study so the value mayunderstate the actual results. The average time to close the gap varies quitesubstantially for gaps in uptrends (70 days) versus those in downtrends (43days). It appears easier for a falling stock to turn around and rise, thereby closing a downward gap, than it is for a stock in a bull market to suddenly declineand go against the flow to close an uptrend gap.The percentage of gaps closing within 1 week is just 11 % and 10%. Thisis normal since continuation gaps occur and prices continue moving along theprevailing trend and do not curl around and quickly close.The volume figures in Table 16.4 compare with a 25-day moving averageof the volume. On the day of the gap, volume is more than twice normal andremains high.Compared with the overall trend, I measured the position of the gap inboth time and price. Timewise, the gap occurs 48% of the way to the end ofthe uptrend and 58% of the way to the end for downtrends. For both up anddown trends, the trend length is computed, in days, and compared with thetrend start to the day before the gap opens.With price, the gaps occur 48% and 50% of the way from the trend startto the gap center for up and down trends, respectively. The numbers supportthe theory that a continuation gap occurs near the middle of trends. In uptrends, prices move a little further after the gap. Since the numbers are averages, your result will vary.
Statistics: Exhaustion GapsTable 16.5 shows statistics for exhaustion gaps. I uncovered 159 exhaustion gapsin 100 stocks, comparatively few for all gap types. From the gap to the end of thetrend, the gain is 6% for uptrends and the loss is 5% for downtrends. Since theexhaustion gap marks the end of the trend, these low numbers make sense. It alsofollows that the most likely rise, 3%, and decline, 3% to 4%, is small.Where in the yearly price trend do exhaustion gaps occur? Most gaps inan uptrend occur in the upper third of the yearly price range, whereas the lowest third of the range scores best for exhaustion gaps in a downtrend. Thismakes intuitive sense as uptrends may set a new yearly high and downtrends anew yearly low before the trend ends. The performance of the gaps over theyearly price range was not measured because of the small average gains orlosses registered.
249
Table 16.5Statistics for Exhaustion GapsDescriptionNumber of formations in100 stocks from 1991 to 1996
Average rise or declineMost likely rise or decline
Uptrends
Downtrends
636%3%
965%Between 3% or 4%
Percentage of gaps occurringnear 12-month low (L),center (C), or high (H)
19%, C14%, H77%
L41%, C37%, H22%
Number of gaps closed in 1 year
62 or 98%
94 or 98%
Average time to close the gap
23 days58%
17 days
280%, 144%, 120%,121%, 108%, 95%
295%, 172%, 127%,108%, 105%, 117%
Percentage of gaps closed in 1 weekVolume for gap day and next 5days compared with 25-daymoving average
72%
Nearly all (98%) of the gaps close in just 23 days (uptrends) and 17 days(downtrends). The high closing value in such a short time reinforces the beliefthat exhaustion gaps occur near the end of trends. The number of gaps closedin a week ranges between 58% for uptrends and 72% for downtrends.Table 16.5 shows gap volume and volume up to a week later. At the start,volume is almost triple the average but drops to just slightly above normal aweek later.
Trading Tactics and Sample TradeTable 16.6 lists trading tactics for gaps. To successfully trade gaps you have tobe quick, making sure to use stops, and you have to be ready to close out a tradeat a moment's notice. Still, they can be profitable. Consider what Gina did withthe situation shown in Figure 16.3.As a seasoned investor, Gina knew all about gaps and practiced tradingthem on paper until she was successful most of the time. The practice honedher skills and pulling the trigger seemed rote. With a focus on limiting herlosses, she was growing confident that her trading style was one that wouldallow her to succeed in the markets, so she took the leap and decided to tradeher system for real.She followed the stock for quite a long time and was both familiar andcomfortable with the fundamentals of the company. When she noticed thebreakaway gap occur on May 10, she quickly checked the identification guidelines. Volume was above average (although it may not be clear from the chart)
Trading Tactics and Sample Trade
Table 16.6Trading Tactics for Various GapsTrading Tactic
Explanation
Area gapsBreakaway gaps
These gaps are too short-lived to be traded profitably, consistently.If high volume is present at the start of a trend, then trade withthe trend. Verify gap type by reviewing the identificationguidelines before trading.Continuation gaps usually mark the halfway point so you cangauge the eventual price move. Measure from the trend start tothe gap center and project the difference from the gap center tothe predicted high or low.
Continuation gaps
Exhaustion gaps
Stop loss
Apr 96
If an abnormally wide gap occurs or a gap occurs at the end of atrend, then close out your position when the trend reverses. Aftera trend reversal, consider trading the new trend (shorting thestock if the prior trend was up). Violent reversals often followexhaustion gaps. Close out the trade the day after new highs (foruptrends) or new lows (downtrends) fail to occur.The lower rim (for uptrends) or the higher rim (for downtrends) ofa gap is a good place to put a stop ('/a or so away from the rim).Gaps provide near-term support or resistance, so this works wellwith those gaps that do not close quickly.
May
|un
jul
Figure 16.3 Cap trading. Gina bought the stock on the breakaway gap and soldit a few days later for a $7,500 profit. Then she shorted the stock as the exhaustiongap turned into a dead-cat bounce.
250
251
and a new upward price trend seemed to be forming. She called her broker andbought 1,000 shares receiving a fill at 58 that day.She placed a stop-loss order at 57, H below the lower gap rim just to besafe. If this turned out to be an area gap, she would probably be stopped out fora small loss. During her paper trading days, she discovered that most gaps provide near-term support or resistance, so she was confident that her stop wouldhold.She watched the stock closely. Two days later the stock gapped again. Itcould either be a continuation gap or an exhaustion gap, she decided. Volumewas heavy, about twice the 2 5-day moving average, so that offered no clue. Thefollowing day, when prices gapped again, she knew that the prior pattern wasa continuation gap.Gina checked the price chart and using the center of the continuation gapas a midpoint, she measured from the trend low (point A in the figure) to thecenter of the gap. The difference was 5l/i (that is, 60!/4 - 543/4). Adding the difference to the middle of the continuation gap predicted that prices would topout at 653/4, so she placed a stop at 65H and moments later, the stock was sold.That day, the stock climbed to a high of 66, slightly above the predicted price,and closed the day at 631A.Not including commission charges, she made $7,500 in just 3 days. Butshe was not done. The large daily price range on high volume when she soldreminded her of a one-day reversal, but she was unsure. She decided to keepher options open and look for an opportunity to sell short. She followed thestock daily and when it closed below the support level at 61 she decided to sellthe stock short and received a fill at 59.The next day she was surprised to discover that a large exhaustion gap hadformed, dropping the stock down to 49, a $10,000 gain overnight. Knowingthat the gap was in reality a dead-cat bounce, she changed tactics and did notimmediately close out her position. Instead, she watched the stock bounceupward for a few days then continue lower (as the formation predicts). Insteadof getting greedy, she decided to close out her position and received a fill at 45,for an easy $14,000 profit in less than 2 weeks.If you think Gina was lucky, netting over $21,000 in 2 weeks, you areprobably right. But her ability to correctly size up an investment opportunityand act on it quickly while taking steps to minimize losses goes a long way toexplaining her luck. Some call it skill.Gina is a serious investor who leaves nothing to chance. She did not justjump in and start trading gaps after reading about it in some book. Instead sheresearched the formation and developed a successful trading style that incorporates gaps.
Tour and Identification Guidelines
17Hanging Man
253
works. One is that when the closing price is "near" (whatever that means) thedaily high, then there is an 80% chance the following day will see a higherhigh. The statistics later in this chapter show that the best performance I couldcome up with is between 55% and 57%. Perhaps the theory relates to securitytypes other than common stocks. For stocks held overnight anyway, the 55%chance that tomorrow's high will exceed today's is slightly better than a cointoss and is probably a wash if you compensate for the upward bias of the stock
market over time.The other theory, and one that the 67% failure rate pertains to in theResults Snapshot, is when both the daily open and close are "near" the dailyhigh but the stock trades "significantly lower" intraday in a rising price trend.
A hanging man formation under those conditions supposedly signals a bearishtrend reversal. This only works a third of the time—a huge disappointment.I looked at the failure rates in the more traditional sense and came up withbetter values. For those formations with upside breakouts, just 11 % of the formations fail to move higher than 5% before changing direction and heading
down. On the flip side, 22% of the formations with downside breakouts are 5%failures. This is above the suggested maximum failure rate of 20% that I consider acceptable.RESULTS SNAPSHOTUpside BreakoutAppearance
An opening and closing price that is at or near thedaily high with a significantly lower intraday low
Reversal or consolidation
Short-term (up to 3 months) bullish reversal
Failure rate
Since the breakout should be downward, in a risingprice trend, 67% have upside breakouts. The 5%failure rate is 11 %.
Average rise
40%, with the most likely rise being 10%
Tour and Identification GuidelinesTable 17.1 shows the identification guidelines for the hanging man formation.If you have the four daily prices available—open, high, low, and close—that isall you need. The open, high, and close should all be the same. This means that
the horizontal bar on the chart will be at the top of the figure (it will look likethe capital letter T).
Downside BreakoutAppearance
An opening and closing price that is at or near thedaily high with a significantly lower intraday low
Reversal or consolidation
Consolidation with short-term (up to 3 months)bearish implications
Failure rate
Not applicable. By definition, the breakout should bedownward. The 5% failure rate is 22%.
Average decline
16%, with the most likely loss between 5% and 10%
The hanging man formation is really a candlestick formation adapted to noncandlestick charts. There are two main theories about how this formation
252
Hanging man formations with upside breakouts show gains averaging 40%,which is quite good, but the most likely gain is 10%—comparatively poor. Fordownside breakouts, the average loss is 16% with a likely loss between 5% and10%. If you decide to trade this formation, do not expect a large price move.
Table 17.1Identification Characteristics of Hanging Man ReversalCharacteristic
Description
Open = high = close
The daily open, high, and closing prices must be the samevalue. On an open-high-low-close chart, it looks like theletter T.
Significantly lower low
The intraday low price must be significantly lower than theintraday high price. This means 5% or more.
Rising price trend
The price trend must be rising
254
Focus on Failures
Hanging Man
The intraday low should be significantly lower than the intraday high. I
interpret the phrase significantly lower to mean more than 5%. This arbitrarilychosen value results in a decent sample size for the statistics. If you do not like5%, then choose another value. The results do not vary that much. Changing
the benchmark from 5% to 2.5%, 7.5%, or even 10% causes the failure rate tovary from 59% to 75%. No matter how you slice it, it is still terrible—wellabove the 20% maximum.
The final criterion for selecting hanging man reversals is to find themduring an uptrend. Since we are