The technical patterns on charts known as ‘gaps’ may not be of great interest to investors with a longer-term outlook, but to the technical trader a gap can provide a detailed insight into a likely future price direction in the short term.
Firstly, let’s look at why gaps occur.
The markets are designed to be as orderly as possible in determining price points. The problem with this is that equity markets in most countries only trade about six hours a day, leaving 18-hours during which stocks cannot be traded, despite the constant flow of new information. For example, mining company stocks are constantly being revalued as commodity prices fluctuate or a bio-tech company could announce a significant research breakthrough.
So assuming yesterday’s closing price is a reasonable opening price today is fraught with problems. If new, positive information is received overnight, a company’s price is likely to jump on opening or ‘gap’. The opening price is determined by the bid and ask prices prior to market and the point at which these prices match is where the market will open. Of course there is no guarantee that the price will hold there but the dynamic design of markets means they have to start the trading day somewhere.
Traders should factor-in the frequency of gaps into their trading plans, based on how likely they are to occur in the markets they are looking to trade. Telstra, for example, has a low gaps frequency so a gap can mean something really big is happening. On the other hand, frequent gaps occur for stocks like Rio Tinto because it is dual-listed (i.e. it is trading on more than just the ASX exchange) and is also at the mercy of commodity and currency price movements.
When we look at the chart for Rio we see multiple gaps in the price action as a result of fluctuations in the variables that go into pricing the stock. So, what does this mean for future price direction?
Markets abhor gaps, which is why they love to fill them. If a gap is formed you can expect the market o retest and attempt to close it. If the gap cannot be closed, it’s a real signal that the market is strong in that direction. Gaps can be seen as resistance and support and we can make decisions based on where they form, if they get filled. We can also apply other filters such as the volume activity around those levels.
Rio is a stock that gaps regularly. The current market volatility and the frequency of gaps on Rio stock suggests there is a degree of uncertainty, so we can expect more gaps in the short-term. Out of the June 20th low we see the Rio price action gap up and the low on the 27th fail to fill the gap. In short, it acts like a cushion of air and supports the potential for upside movement.
The top that occurred on July 8th formed with what we call an ‘island reversal pattern’ (confirmed on July 9th) as the price action gapped up and then gapped down again. This pattern can be used to identify reversals in the market.
Around the lows on July 14th and the tops on July 21st we have a number of island reversal patterns. In the bigger picture these gaps are above the price action so resistance is in play. If the price action decreases, the gap around $79 will likely be seen as support, if only in the short-term. If it’s broken then lows of $77 could be a target.
In the current climate, gaps are prevalent and we should take heed of what the market is quietly telling us. Watching for the market to clear the gaps could be worthwhile but if you are more aggressive they can allow you to take speculative positions and anticipate price moves.
Good Trading
Aaron Lynch
