Stock Quotes in this Article: CSCO

BALTIMORE (Stockpickr) -- As a trader, gaps may well be one of the most challenging things you’ll find on a chart. That’s because as common as these missing spots in a stock’s price may be, it’s clear that they’re sorely misunderstood by all manner of market participants.

But it doesn’t have to be that way. Instead, gaps can provide a wealth of information about how a stock’s behaving and even signal trades to in-the-know investors.

Today, we’ll dive into the gaps for a trader’s eye view of how to handle them.

To start, we should define exactly what a gap is. Simply put, gaps are missing chunks on a stock’s price chart where prices move through, but no shares traded. They can occur for a bevy of reasons, but common catalysts for gaps include major news (often outside of trading hours) or serious sentiment shifts. The chart of Cisco (CSCO) below gives two good examples of conspicuous gaps:

You won’t see all gaps on traditional daily candlestick charts such as Cisco’s. That’s because gaps also occur intraday but appear as part of an individual candle. For most traders, that’s not a major issue -- the most technically significant gaps are the ones that show up on your trading time frame of choice.

One big myth that needs to be clarified from the get-go is the misconception that all (or most) gaps are eventually filled. A number of independent analysts have shown that trading strategies based on that assumption are woefully unprofitable. Don’t fall for it.

Understanding Gap Types

The trading implications of any gap first depend on identifying which type of gap you’re looking at. First, though, it’s worthwhile to identify gap types that don’t carry any technical value.

The first is the common or area gap, which occurs within an already-defined trading range. Because these gaps don’t carry any significant price implications, they can largely be ignored.

Suspension gaps are another type of gap that’s not technically important but are worth understanding nonetheless. This kind of gap occurs in securities that trade outside of regular U.S. equity trading hours, such as ADRs or commodity ETFs. Because price discovery is taking place constantly, the pricing on a U.S. exchange appears filled with small gaps. These too can be ignored for the purposes of technical analysis.

Other types of gaps are crucial. The first is the breakaway gap, which actually represents a breakout in shares out of a trading range or technical pattern. For a gap to be considered a breakaway gap, shares of the stock in question need to clear a resistance or support level, then continue in the direction of the breakout. Because breakaway gaps are the beginning of a substantive price move, traders should plan on making a bet in the direction of the gap.

Another significant gap type is the runaway or continuation gap, which occurs in the middle of a trending stock’s movement. The fact that the stock is already trending is important because it differentiates the runaway gap from unimportant common gaps, which occur in ranging stocks. As with a runaway gap, traders will want to place a bet in the direction of the gap to take advantage of the price movement.

The last kind of significant gap is the exhaustion gap, which represents the end of a price move. Exhaustion gaps may appear like runaway or breakaway gaps initially, but they quickly reverse and fill. In these cases, the trading implication is away from the direction of the gap.

The Predictive Power of Gaps

As you’ve likely surmised, the important gaps can’t be identified until after the fact. That’s a common criticism of trading gaps, but it’s a misguided one. While gaps are often large, quick price moves that traders would like to take advantage of regularly, the point of gap analysis isn’t to catch gaps; instead, the point is to initiate profitable trades based on the days following a gap.

(While some technical tools, such as DeMark Indicators, have been effective at identifying stocks with a likelihood of gaps due to accumulation or distribution of shares, putting them into practice is beyond the scope of this article.)

New research on gaps suggests that the predictive power of these voids on a stock chart shouldn’t be overlooked. In their award-winning paper, Analyzing Gaps for Profitable Trading Strategies, Julie Dahlquist and Richard Bauer found statistically impressive correlations that could be drawn between gaps and excess returns. They concluded that gap up days with white candles were associated with higher returns, as were larger-percentage gaps, gaps preceded by a black candle and gaps occurring below the 10-day moving average.

Surprisingly, Dahlquist and Bauer found that while gap downs were shortable in the near-term, longer-term they actually outperformed the market. That’s an especially important statistic to keep in mind for breakaway or runaway gaps to the downside.

While gaps are bound to remain an enigmatic stock chart occurrence to most traders, they’re far from an unpredictable -- and more important, they’re far from untradeable. The next time you see a gap in a stock, remember that the key to its identification is waiting to see how the price action resolves itself over the next few bars. And remember -- don’t get caught up on the move you missed in the gap. Instead, keep your focus on the move to follow.

Next time, we’ll add to your technical repertoire with another primer that will bring you closer to implementing technical analysis for your portfolio.

In the meantime, do you have a burning technical analysis question? Get it answered by heading to Stockpickr Answers.

-- Written by Jonas Elmerraji in Baltimore.

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>>5 Stocks Setting Up to Break Out
>>Understanding Market Momentum

>>Does Technical Trading Really Work?

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Jonas Elmerraji, based out of Baltimore, is the editor and portfolio manager of the Rhino Stock Report, a free investment advisory that returned 15% in 2008. He is a contributor to numerous financial outlets, including Forbes and Investopedia, and has been featured in Investor's Business Daily, in Consumer's Digest and on MSNBC.com.