In last week's issue I introduced you to the subject of gaps. However, I only got about halfway through my analysis. So, as promised, here is Part #2. If you haven't done so already, I strongly recommend you review last week's Educational Bonus.

GAPS ARE NOT ALWAYS FILLED
How many times have you read this brilliant little piece of analysis:

"Company XYZ's stock gapped higher today. Our recommendation is to look for the stock to fill its gap (since gaps are always filled) and buy at that time."

Come on, raise your hands! You must have seen this little bit of market lore before.

(In case you don't know, when a stock "fills a gap," it merely means that prices trade back to where the gap began. For example, if IBM gaps lower from $85 to $82 and then moves back to $85 or higher, the gap is considered to be "filled.")

If you recall, I wrote about two types of gaps last week -- "common" gaps and "measuring" gaps. Common gaps are typically filled, as they are not caused by exceptional changes in the market or its underlying supply/demand dynamic. (Although many other gaps will eventually get filled, it's worth noting that they might not get filled within the current trend cycle. For example, if a stock gaps from $10 to $12 and you are waiting for the gap to fill, and it only does so after reaching $35 first, then the fact that it got filled might technically be true, but it has no meaning with regard to the importance of that original gap.)

The two types of gaps that are typically filled fairly quickly (within the same trend cycle) are "common" gaps and "exhaustion" gaps (I will cover the latter topic below). "Measuring" gaps and "breakaway" gaps (I'll analyze breakaway gaps later in this lesson) typically do not get filled until after the current trend reverses, and might not ever get filled (such as the multitude of downward gaps that occurred as our friends at Enron got carted off to jail).

EXHAUSTION GAPS -- THE LAST HURRAH
The market has been rising inexorably. You're on the sidelines and are grimacing each and every day as your favorite stock keeps moving higher and higher. Finally, you just can't take it anymore. You close your eyes and call your broker (or click your mouse) and put in an order to buy the stock at tomorrow's open. In addition, perhaps you just bought stock in a company that recently announced positive news.

What often happens in this type of scenario? Well, more often than not, you're not alone in your desire to purchase the shares. The market gaps open higher and rallies further, maybe just for that day, and maybe even for a few days or even weeks. Volume is probably very high, but maybe not quite as high as during prior moves higher. In addition, there's a pretty decent chance that the shares have some momentum (RSI, Stochastics, MACD) divergences going. This is a classic example of an "exhaustion" gap.

Exhaustion gaps come at the end of a trend. Somehow, the crowd seems to give in at the same time and a stock, bond, currency or commodity creates a final up or down gap before reversing course. It's kind of like watching Lance Armstrong surge past the field in the Tour de France and go on to victory. (The only difference being that Armstrong keeps going until the race is over, while exhaustion gaps are generally followed by a reversal or consolidation.) Sometimes the market reverses within a day or two. By definition, exhaustion gaps are typically filled very quickly.

Note the chart above, where I've provided you with an example of an exhaustion gap in the Nasdaq-100 Trust (QQQ). See where prices gapped higher amidst a momentum divergence (I've circled the gap in early July on the chart)? Volume was strong, but not as high as during the late-May high. Furthermore, the chart shows a momentum divergence. This does not necessarily mean that QQQ has topped, but it does mean that the trend in force at the time has ended. QQQ has now entered into a period of consolidation.

BREAKAWAY GAPS -- TELL ME SOMETHING NEW
A "breakaway" gap is essentially the opposite of an exhaustion gap. This type of gap occurs when a trend reverses powerfully, creating a gap in the opposite direction (for example, a gap down after an uptrend, or a gap up following a downtrend). Occasionally, breakaway gaps will occur following a period of consolidation. Other times, the gaps might not occur until a trendline break or upon confirmation of breaking a head and shoulders neckline. They also sometimes take place following a rounded bottom or top. Regardless of when it happens, a breakaway gap is most reliable if it occurs amidst increased volume. Breakaway gaps are usually not filled until after the trend reverses again, and in some cases they are never filled.

In the historical chart for Sapient (SAPE, $3.41) shown above, note the two distinct breakaway gaps (again, I've placed a circle around each gap). The first one was filled quickly, but the later one, on a trendline break, still has not been filled. Given that Sapient is now about 95% beneath its all-time high, it is fairly unlikely that SAPE will ever fill that gap again.

ISLAND REVERSALS -- SHARK INFESTED WATERS?
An "island reversal," which is an exhaustion gap followed by a breakaway gap, is a pattern that has become something of an urban legend. First of all, nobody really seems to get the darn thing right. As an example of this, please take a look at the five statements below -- all of which I've seen written by newsletter writers and supposed "technical experts." Which do you think are correct (note that some of these are contradictory)?

1. An island reversal can only have one day between the exhaustion and breakaway gaps.
2. An island reversal must have several days between the gaps.
3. An island reversal is a major reversal signal.
4. It is not an island reversal if the two gaps do not have some prices in common.
5. It is not an island reversal if the exhaustion gap is filled before the breakaway gap happens.

The correct answer is that NOT A SINGLE ONE of the above statements is strictly true! There can be several days between the exhaustion and breakaway gaps. This is one of the more hysterical bits of silliness I've seen on the Internet, as some sites say that one day is not enough, while others swear that an island reversal has not occurred if more than one day passes between the gaps. Amazingly, you can't believe everything you read!

Number four above is a more matter of figuring out which is a better signal. While the two gaps need not have prices in common, an island reversal is considered to be a better signal if the two have some gap area in common.

Finally, while most island reversals do meet the requirement noted in choice 5 (exhaustion not filled first), not all do. In the chart of the iShares Lehman 20+ Year Treasury Bond Fund (TLT, $82.51) shown above, the pattern does qualify as an island reversal even though the exhaustion gap got filled before the breakaway gap took place.

PUTTING IT ALL TOGETHER -- TRADING GAPS
I cannot overemphasize the importance of trading gaps with great caution. In particular, in order to trade them effectively, you need to be able to quickly distinguish between the various kinds of gaps (common, measuring, exhaustion or breakaway). After doing so, here are a few ideas as to how you might want to trade each respective gap...

Common gaps:

• These have no predictive power
• There is no reason to trade after a common gap

Measuring gaps:

• These occur after strong move only, otherwise you're probably looking at a common gap.
• For up gap, buy on the gap. Place stops just beneath gap support (high of the day prior to the gap).
• If volume is not strong on gap day, then it probably is not a meaningful gap and will likely prove to be a common gap. Do not trade without increased volume.

Exhaustion gap:

• Exhaustion gaps are not actionable. There is no trade signal at the time of the gap.
• Exhaustion gaps warn that the current trend may be ending.
• When this type of gap is filled, enter a position with stops just beyond the prior extreme. For example, if the stock is ending an uptrend, then set your stop above the high so far. If the stock is ending a downtrend, then set your stop beneath the low thus far.
• Remember -- there must be a trend to reverse. If the stock has not been in a steady trend, then there can be no exhaustion gap.
• Wide gaps provide better signals.
• Remember that an exhaustion gap could signal a change from an uptrend to a downtrend (or vice versa). Alternatively, it could also mark a change in trend from up or down to sideways.
• If implied volatility (as measured by options prices) is high, then you can sell out-of-the-money options with strike prices beyond the recent price extremes. This would work best at the end of downtrend, which is when volatility is often high. Volatility is not high right now, so this strategy probably will be more useful when stocks turn lower.
• If you're selling naked options, then make sure your time to expiration is short since the exhaustion gap might only lead to a consolidation. When there is very little time to expiration, the time value of an option falls at an extremely fast clip.

Breakaway gaps:

• Breakaway gaps provide the best trading signals when volume increases on the break.
• The probability of profitable trade increases if gap is over a trendline or a head and shoulders neckline.
• Another good place to look for a breakaway gap is at the end of an A-B-C or 1-2-3-4-5 Elliott Wave pattern.
• Momentum divergences add to confidence of a gap being a breakaway.
• Remember -- sometimes breakaway gaps are filled initially, so do not place your stops on gap fill (see the TLT chart above). Instead, place them above the high (for a break lower) or below the low (for a break higher).

CONCLUSION
The great thing about gaps is that they provide you with both excellent entry signals and clear stop levels. However, in order to trade them profitably, you must ensure that you truly have something other than a common gap. I know I've repeated this mantra several times, but if there was no trend to reverse, then the gap you see on the chart likely has no meaning. It can only be important if you are breaking out of a trading range, extending a powerful move or reversing an existing trend. Hopefully, this week's and last week's lesson will put you on the right track to trading gaps profitably.

Steven Poser
Editor
The ETF Authority
New York, NY