at least twoor three days prior to the gap formation.5. Gaps below the markets act as support and above the markets act as resistance.6. In most cases, index futures' opening gaps tend to fill during the same trading day.7. Common gap trading should be avoided by most traders.8. During Gap trading, protect your trades using trail stops.9. A valid breakaway gap almost never gets filled. Hence, all "Gaps" get filled is onlypartially true.10. If a daily stock gap is 2.5 times the 10-day ATR, ignore the trade until at least thefollowing day.
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Gap TypesCommon GapCommon gaps form more often in quiet andtrend less markets with a small increase involume. Common Gaps occur more oftenthan other Gap forms. These Gaps should beavoided by most traders if the gap range isvery small. Some experienced traders maytrade common Gaps with quick entry andexit rules. Trading against (fading) thecommon gap is the only way to profit fromcommon gap patterns. These trades should bequick as an entry of "short" may be placedfor an upside gap, as the prices reach newhighs. Place a stop above the new high, andplace targets at the lower-end of the gaprange. For a downside gap, wait for pricesmaking new lows and enter a "long" trade.Place a "stop" below the recent low, andplace a target near the high of the gap range.Breakaway Gap
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Breakaway gaps are most reliable and areeasy to visually detect. Breakaway gapsoccur when prices rise out of a congestionzones or long base trading areas. Theyusually have heavy volume on the breakout.These gaps do not close quickly as theyinitiate a trend from congestion zone and stayin the trend for a long time before a reversaloccurs. From the congestion zone breakout,prices make higher highs for a few bars,usually with gaps in between them, and forbreakdowns prices they make lower-lows fora few bars. Breakaway Gaps present anexcellent trading opportunity. Enter at thebeginning of the trend in a breakaway gapand place a "stop" order below the low of thebar prior to the gap. Targets usually set aprevious major swing high. Close the tradeafter 3 to 4 days of upside movement.
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Gap TypesContinuation Gap
Most daily gaps tend to fill during thefollowing few weeks. In the case ofContinuation gaps, prices make new highs, ornew lows, without filling the gap forextended periods of time. Continuation Gapsare signaling a continuation of an existingtrend. The Breakaway gap forms at the startof a trend, while a Continuation gap forms inthe middle of trend. Moreover, the volumeduring the Continuous gaps is heavy. Pricesshould make new highs or new lowsimmediately after the gap to "continue" theprior trend. Trading Continuous gaps couldbe relatively easy as the trend direction isclearly established prior to the gap
Exhaustion Gap
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An Exhaustion gap occurs near the end of thetrend and is not followed by new highs ornew lows after the gap bar. Exhaustion gapsare great trading opportunities for reversalsignals, as markets tend to fall or riseviolently after the gap formation. These gapscan be easily detected as the prices reversequickly after a gap and prices attempt toclose below the gap. After an Exhaustiongap, enter a "short" trade below the low ofthe gap bar, and place a "stop" above theswing high of the pattern. Exhaustion gapsresult in extensive sell- offs from the prioruptrend. Place targets near the swing lowsprior to the Exhaustion gap trend rally.
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Trading Exhaustion Gap
Conhnuous Gap
Trading Exhaustion GapThe example above illustrates an "Exhaustion gap" setup from the Google7s(GOOG) dailychart. A series of other Gaps are also shown in the example above. From April to May 2006,GOOG expanded making higher highs and traded from $340 to $450. In the middle of April2006, GOOG released its earnings. Subsequently, GOOG gapped (exhaustion) open from$41 5 to $435 and traded as high as $450. After a few days from the earnings report release,GOOG failed to continue its higher closes and traded below the low of the gap bar at $435 toconfirm an Exhaustion gap setup.1. Enter a "short" trade below the low of the gap bar at $435.2. Place a "stop" order above the high of the gap bar $45 I .3. Enter a target near the previous "swing low" prior to the exhaustion gap at $400.
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Trading Breakaway Gap.
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Trading Breakaway GapThe example above illustrates a Breakaway gap setup from the Sepracor's (SEPR) daily chart.Breakaway gaps develop from consolidation zones and are not filled for a long time. SEPRtraded in a consolidation zone after an extended rally from December to January, 2006. In lateJanuary 2006, a Breakaway gap was created as SEPR expanded its trading range to downsidefrom $60 to $57.75.
1. Enter a "short" trade below the low of the gap bar at $56.2. Place a "stop" order above the high of the gap range at $60.3. Place a target near the major swing low prior to the rally at $50.
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Dead Cat BounceThe "Dead Cat Bounce" pattern is an event driven pattern that occurs due to some sudden,major event or news related events such as a corporate earnings report, merger, takeover,partnership, resignationslappointment and scandal; Federal Drug Administration (FDA)approval and Securities Exchange Commission (SEC) inquiries in a company. From theregular trading price pattern, price usually drops or rises at least 15% or more to indicate theseriousness and reaction to the event. As this condition emerges, traders enter a trade in theopposite direction of the event and trade a rise or drop about half of the event price change atsome leisurely rate. This makes it a "Dead Cat Bounce Pattern". Once the news settles, theprice reverses the bounce and trades in the original event driven direction. This pattern has bulland bearish setups. This pattern also has high failure rate as some of these gaps are neverretraced or filled for very long time.Trade: It may be easy to trade the pattern once the "Dead Cat Bounce" occurs rather thanchasing the event driven price-action. The riseldrop must be at least 15% of price. Mostbounces are about 50% to 62% of the drop against the event-day direction. For an event drivenprice-fall, enter a short trade at 50% to 62% gap level. Short below the previous bar's low. Foran event-driven price-rise, enter a long trade at 50% to 62% gap level. Enter a long above theprevious bar's high.Stop:Place a stop loss order at the event-days' gap levels. For a short trade, place a stop at the highof the event-day's gap down bar. For a long trade, place a stop below the low of the eventday's gap up bar.
Target: The target is placed about 100% of the gap range from the trade entry.5/14/078:21 PM
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The example above shows a Dead Cat Bounce pattern from the Yahoo's daily chart. Yahooannounced its earnings in late July 2006 and as a result its stock dropped from $3 1 to $25.From mid July to August 2006, Yahoo attempted to close the gap as it bounced back from $25to $30. The gap range generated by Yahoo's news was $4. In September 2006, Yahoo gave anopportunity to "short" at 50% level (at $29).I. Enter a "short" trade below the previous bar's low at 50% level of gap (at D:$28.50).2. Place a "stop" order above the top of the gap at A (at $3 1.25).3. Place a "target" at 100% of the gap range from the trade entry (at $24).
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Trading Dead Cat Bounce Pattern
Trading Dead Cat Bounce (Upside) Pattern
The example above illustrates an upside Dead Cat Bounce pattern from the Infospace's(INSP) daily chart. During August 2004, Infospace gap opened from $30 to $35. After a fewsessions, Infospace retraced its rally into the gap. The gap range was $5. Infospace retracedabout 50% of its gap range and presented a "long" trade opportunity.1. Enter a "long" trade above the high of the previous bar at C (at $34).
2. Place a "stop" order at the lower gap (at $3 1).3. Place a "target" at 100% of gap range from the entry level to D (at $39).
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Island Reversal Pattern
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Island Reversals are part of price gap structures, and form when prices are isolated by gaps onboth sides of the price rally or price decline. In an extended rally, price rallies above the priorsessions close and form an upside gap. After few sessions, a downside gap is formed to closebelow the prior sessions close. This isolation of price-range forms an Island Reversal setup,which usually signals much larger technical declines in bullish trends, or rallies in bearishtrends.Most Island reversals are usually news driven events. Volume should be at higher levels onboth sides of the gaps. It is very rare to see an Island Reversal pattern in the middle of a rallyas they reverse the prior trends after the second gap.Trade:After a reversal, enter a "short" trade (for uptrend) below the low of the second down gap. Or,enter a "long" trade (in a down trend) above the high of the second gap up.Stop:Place a "stop" order if the market closes above the high of the "Island Reversal" pattern forshorts, or if it closes below the low of the Island Reversal pattern for longs.Target: Island Reversals usually are very profitable as they signal a weakness in the currenttrend. Targets are placed near key event driven support or resistance levels.
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Trade Chart Patterns Like The Pros
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Trading Island Reversal PatternThe chart above illustrates an Island Reversal pattern from Amgen's (AMGN) daily chart.During 2006, AMGN rallied to $76 and reversed to $56 by April of 2007. Late January 2007,AMGN showed its first upside gap and closed at $76. Within the next few sessions, AMGNclosed the first gap and formed a downside gap to complete an "Island Reversal Pattern."1. Enter a "short" trade one tick below the low of the second gap bar.2. Place a "stop" order above the high of the bar prior to the gap.3. Target a major "swing low" prior to the rally.
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Trading Island Reversal
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Trading Island ReversalThe example above illustrates an Island Reversal pattern in Broadcom (BRCM) daily chart. InMarch 2003, BRCM gapped down at $10 price level and traded for few bars lower. Late April2003, BRCM reversed its downtrend and traded higher with gap closing above the previousdownside gap. This scenario created an "Island Reversal" pattern and provided a "long" tradeopportunity.1. Enter a "long" trade above the Gap bar's high at $1 1.2. Place a "stop" below the low of the Gap at $9.753. Place a "target" near a major "swing h i g h prior to the downside gap.
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DefinitionsBreakdown: Current price surpassing a series of support prices and trading below itBreakout: Current Price overcoming a series of resistance prices and trading above itCongestion: Market in short-term and choppy price-rangeDivergence: When two or more averages or indices fail to show confirming trends.Drawdown: The reduction in account equity as a result of a trade or series of trades.Entry: A new trade (Could be "Buy" or "Sell")Exit: Closing the trade (Could be "Sell" or "Buy to Cover")Extension: Price levels surpassing a previous Swing in the same direction as prior swingFib. :Abbreviation for FibonacciFibonacci Ratio: he ratio between any two successive numbers in the Fibonacci sequence,known as phi (f).Fractals: Depiction of mathematical models that may be applied to identify data patterns.Gap: Current Price Opening away (Up or Down) from the previous bar's Close.Impulse Wave: A wave or cycle of waves that carries the current trend further in the samedirection.Long: A Buy entryMinute Chart: The time period for the chart is [n] minutes.Neckline: A trendline drawn along the support or resistance points of various reversal andconsolidation pattern (i.e., head and shoulder, double and triple toplbottom formations).Opening Range: The range of prices that occur during the first five minutes to first hour oftrading, depending on the preference of the individual analyst.Overbought: Market prices that have risen too steeply and too fast.Oversold: Market prices that have declined too steeply and too fast.Pivot: A key price level where prices change or reverse its prior directionRange: The distance between two price points (usually High and Low)Resistance: Prices where selling pressure accumulatesRetracement: Price reversing from an upside advance or a downside decline (within a swing).Short: A Sell entrySpike: A sharp rise in price in a single day or two; may be as great as 15-30%, indicating thetime for an immediate sale.Stop Loss: The risk management technique in which the trade is liquidated to halt any furtherdecline in value.Support: Prices where buying pressure accumulatesSwing: The distance between two key pivot points (continuous)Target: A profit price level from a trade entry.Tick: The minimum price movement in a stock or contract.Trendline: A line drawn that connects either a series of highs or lows in a trend.
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Bibliography1. "Dynamic Time and Price Analysis of Market Trends" by Bryce Gilmore.2. "The Harmonic Trader" by Scott M . Carney3. "Harmonic Trading of the Financial Markets: Vol. One" by Scott Carney4. "Harmonic Trading of the Financial Markets: Vol. Two" by Scott Carney5. "New Frontiers in Fibonacci Trading" by Michael Jardine6. "Fibonacci Ratios with Pattern Recognition" by Larry Pesavento7. "Street Smarts" by Larry Connors and Linda Raschke8. "Fibonaccifor the Active Trader" by Derrick Hobbs9. "Profits in the Stock Market" by H.M. Gartley1 O."Geometry of Markets I " by Bryce Gilmore1 1 ."Geometry of Markets IT' by Bryce Gilmore12."Beyond Candlesticks" by Steve Nison13 ."Japanese Candlestick Charts" by Steve Nison14."Technical Analyis and Stock Market Profits" by Richard Schawbacker1 S."Trading for A Living" by Dr. Alexandar Elder1&"The Symmetric Wave Trading Method" by Michael Gur17."Essential Technical Analysis" by Steven Leigh1 %"The Ultimate Trading Guide" by John Hill, George Pruitt and Lundy Hill19."High Probability Day Trades In The Futures Markets" by J.T. Jackson20."Advanced Commodity Trading Techniques " by J.D. Hamon2 1 . "Advanced Trading Strategies " by Laurence Connors22. "Fibonacci Applications and Strategies for Traders" by Robert Fischer23. "The New Science of Technical Analysis" by Tom DeMark24. "Trading to WinJ'-byAri Kiev25. "The Disciplined Online Investor" by Steven Hendlin26. "Market Wizards", "The New Market Wizards" by Jack Schwager27."Principles of Professional Speculation" by Victor Sperandeo28."The Winning Trader" by Michael Shopshire29."How to be a Successful Trader" by Dr. Ned Gandevani30."Mastering the Trade" by John F. Carter3 1 . "Momentum, Direction and Divergence" by William Blau32."Build Winning Trading Systems" by George Pruitt and John R. Hill33."Day Trading with Short Term Price Patterns" by Toby Crabel34."Secrets of the Undergroundtrader" by Jea Yu and Russell Lockhart35."Forex Tradingfor Maximum ProJit" by Raghee Horner
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About the AuthorSuri Duddella is a successful, private trader for the past 12 years using hisproprietary mathematical models and analysis. Prior to joining the financialmarkets, Suri was an engineering consultant for Fortune 100 companies.Suri Duddella was a founder of a financial research and analysis company from1998 to 2005 specializing in financial modeling, researchlanalysis, andtechnology architecture for financial institutions, investment research andinvestment media companies. Suri's research company was ranked the "Best ofthe web" by Forbes magazine from 2000 to 2003 and featured in Barrons' as an"Excellent Technical Analysis site" in 2002.Suri Duddella's research has been reviewed and featured in Forbes, Barrons',ActiveTrader, Stocks and Commodities, and Washington Business Journalmagazines and newspapers. Suri has also appeared on various television andradio shows. In addition, he presented his research at various investmentconferences in the United States. Suri has published market analysis articles forActive Trader, Stocks and Commodities, Chartpoint, and Traders Worldmagazines. Suri Duddella's trading methodology and interview was published in"Bulls, Bears and Brains of Financial Internet," John Wiley, 2002 by AdamLeitzes and Joshua Solan.Suri Duddella's research website is at www.suriNotes.com, where he updatessome of his trading perspectives and research ideas. He may be reached atsuriNotes@gmail.com.
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