How many times have you heard people talk about "gaps" in the market? What are these things? How and why do they occur? Why should you care about them when you are trading?

I will attempt to answer these and many other questions over the course of the next two weeks.

WHAT IS A GAP?
A "gap" is a space on a bar chart or candlestick chart where consecutive bars (I will use bars and candlesticks interchangeably) show no price overlap. In other words, either the first bar's low is above then next bar's high (meaning the stock gaps lower), or the first bar's high is beneath the second bar's low (the stock gaps higher). Typically, analysts will refer to gaps that take place from one day's trading to the next. However, gaps may also occur on intraday charts, weekly charts and monthly charts.

WHY DO GAPS OCCUR?
Gaps occur for a variety of different reasons. The three most common causes are:

1. The asset is illiquid.
2. A major news event sends the stock sharply in one direction or the other.
3. A long period of time passes between trades.

Certain illiquid stocks, bonds, futures and options may not trade for minutes, hours, days or even weeks at a time. When this occurs, it is likely that consecutive bars will represent much different market environments -- both specific to the asset under consideration as well as to the market overall. Gaps caused by illiquidity are of little concern to the trader and are not important to your analysis. I strongly recommend staying away from illiquid securities, as it can often prove difficult to gracefully exit a position that has turned sour.

News events are probably the most common cause of major market gaps. For example, say Microsoft (MSFT) closes at $55.00 a share on Monday, and then after the stock market closes the firm announces that sales of Windows 2004 XPM (Xtra Profits for Microsoft) Version 2.0 have tripled forecasts and that customers are upgrading their current PCs like crazy. In all likelihood, MSFT will "gap" open several dollars higher the next morning.

News-driven gaps can create very important chart points. They are often the result of a substantial change in market psychology caused by the news. If prices eventually move back into their prior trading range, however, then it may be seen as a failure for the news to take hold and could represent instead a possible reversal of fortunes.

Time is the third reason why the market may gap higher or lower. In some cases, investor and trader expectations may change over a long weekend, or even just overnight. In other cases, international markets may move sharply in one direction, and when the U.S. market opens, the indices, as well as many individual issues, might gap in that same direction. For that matter, many stocks and bonds may trade in overnight markets, but you will typically look at data that only presents trading during U.S. market hours. This will also cause gaps if the market has moved beyond the prior day's price range. The importance of these gaps vary and will at least partially depend on the size of the gap, the volume on the move and whether the market continues in the same direction as the gap for most of the trading day.

The chart below shows three examples of gaps. The leftmost chart, of a now-delisted Nasdaq stock, 1-800-Attorney (ATTY.PK), contains numerous gaps. These were due to the fact that the stock was highly illiquid (and did not even trade on some days).

The middle chart, of Intel Corporation (INTC), shows two recent gaps, one of which was due to the company's recent earnings announcement.

The rightmost chart of the 10-year Lehman U.S. Government Bond iShares (IEF) shows a gap to open the week. Despite the fact that there was no real news over the prior weekend (July 19th and 20th), the bond market opened weaker anyway.

ARE ALL GAPS CREATED EQUAL?
You know I would never have asked that question if they were! There are four general types of gaps:

• Common
• Measuring
• Exhaustion
• Breakaway

I will discuss each of these concepts below, and will continue this analysis next week...

COMMON GAPS
"Common gaps" are, well, common. They are not really terribly meaningful. The illiquid stock gaps shown in the chart above fit into this category. Also, most gaps caused simply by a long period of market inactivity (a three-day weekend, for example) are of the common variety. Gaps that occur in the middle of trading ranges also are very common and tend to have little meaning. Of course, a priori, you might not know if a gap is common or otherwise. However, during period of quiescent trading, gaps are not likely to add much information unless you see a sudden acceleration or reversal in the trend along with a pick-up in volume. Absent that information, you are probably best off assuming that a gap within a trading range will not prove to be very important.

THE IMPORTANCE OF HAVING SOMETHING TO GAP FROM
I've alluded to the fact that gaps are only meaningful if the market is actually doing something. Gaps caused by illiquid conditions, time, or trading ranges are not likely to lead to important support and resistance levels on a chart. For a gap to prove meaningful, it needs to form as the result of a substantial imbalance between supply and demand. This is likely to occur either at the end of a major trend, the start of a new trend, or in the middle of an accelerating trend. This may be due to technical considerations or even fundamental items, such as news (despite what some of my fellow technical analysts will tell you). If the asset you are looking at is merely going sideways, a gap in the middle of the range is unlikely to be meaningful. The one exception to this would be if the gap led to a breakout of the range, or if the gap occurred on very high volume.

MEASURING GAP
A "measuring gap" occurs in the middle of a powerful move within a trend. The reason it is called a measuring gap is because, in theory, the expected price movement (either higher or lower) from the extreme price on the day before the gap is supposed to be roughly equivalent to the part of the trend that occurred prior to the gap. This idea is similar to the measurement technique for other minor continuation patterns (a continuation pattern is a technical formation that represents a pause in a trend, which, once it ends, should see the trend resume in the same direction) such as flags and pennants. If a particular stock is on a real rocket ship ride, then you may see a series of measuring gaps in the chart. For example, look below at the multitude of gaps in JDS Uniphase (JDSU) as its stock price collapsed in 2001!

I think that's a pretty good chunk of information to digest this week. Next week we'll cover Exhaustion Gaps, Breakaway Gaps, Island Reversals and how to trade these types of patterns. We will also talk about how you can tie gaps into other technical analysis tools when trading.

Steven Poser
Editor
The ETF Authority
New York, NY