Amazon teachs us the Three Types of Gaps

Oct 25, 2007: 11:53 PM CST

Excluding Island Reversals, there are three major types of gaps that occur in technical analysis. Amazon.com does a great job of teaching us the difference between these gaps, as price has presented a near textbook example of the normal progression of the three gap types. Let’s look closer.

1. Breakaway Gap

Breakaway gaps occur after a relatively lengthy period of sideways action, or after a lengthy period of price consolidation. Usually accumulation or distribution is occurring at these points of equilibrium. Eventually, price will break from a base or consolidation area to form a new uptrend. Sometimes this occurs rapidly and on high volume (such as following an earnings announcement) in the form of an early breakway gap.

When you spot a potential breakaway gap, it’s usually a good idea to place a trade and hold for a larger target. Breakaway gaps are the LEAST likely gap to be closed.

2. Continuation Gap

After price has been advancing for a while, some bit of news may shock traders into reevaluating the situation and becoming more bullish (in the case of uptrends), or they become fearful of missing out of a wildly trending stock, and so demand so overcomes supply that another gap forms during an uptrend. Traders may also call these gaps “Measured” Gaps because these tend to occur in the midpoint of an uptrend and one can project how much further price can go before forming a reversal.

When you identify a continuation gap, or are holding a position and are rewarded with such a gap, odds favor continued holding and playing for a target equidistant from the initial breakout. While continuation gaps MAY be closed, odds still favor higher prices are yet to come.

3. Exhaustion Gap

Finally, everyone who wants to buy HAS bought the stock, and sometimes this occurs with a final burst of strength where all the demand is exerted over supply, and price – without buyers – will fall. In addition, savvy traders have been distributing stock on the way up, and may have distributed a large quantity of remaining shares into (following) the gap. The result is an upside gap that is closed either the same day or in subsequent days and price takes out the low of the gap on considerable volume. This is a powerful signal that the trend has likely ended.

If you identify an exhaustion gap, especially if price has already formed at least two previous gaps, it is probably a good idea to take any profit home and consider entering an aggressive reversal entry (in this case, a short-sell trade). Odds favor supply will continuously outweigh demand, especially as traders who are now showing paper losses sell their positions, creating realized losses.

Without discussing these occurrences too much deeper, let’s see if we can identify them on Amazon’s chart:

amzngaps.jpg

While the breakaway gap might not appear to be a gap, the large vertical gray line is actually a high volume bar, confirming the large gap from $45 to $55 which almost hit $65 the day after the gap. We had strong evidence that this breakout was valid and price would likely be going higher for some time.

The continuation gap from $70 to $95 actually occurred in the middle of the recent uptrend (should it be ending now), and traders could have measured from the price at the breakway gap to the continuation gap and then added that value to the continuation gap to obtain a potential price target. In addition, not only do you have information that the price should be going higher (usually following a correction), but you can actually anticipate the range where price is likely to reverse.

The final exhaustion move is yet to play out, but price gapped up very strongly on high (though not record) volume and then the massive gap down the next day further confirmed this as a highly probably exhaustion gap. Granted, it didn’t conform perfectly to the definition, but time will tell whether or not it actually is a true exhaustion move.

Gaps and their implications were discussed by some of the early founders of technical analysis, and are explained in great detail in Edwards and Magee’s classic text Technical Analysis of Stock Trends (considered by some as the Bible of Technical Analysis) and Martin J. Pring’s Technical Analysis Explained.

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