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. 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:


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.


She’s Up… She’s Down! Amazon is out to Get You

Oct 24, 2007: 6:57 PM CST

I have to admit – rampant volatility and major updays followed by major down days are – to me – rare in the market.  So, when such an example happens, it is always interesting to delve deeper and learn what ‘went wrong’ so that we can have a greater chance to profit or avoid mistakes in the future.

Amazon (AMZN) shocked a lot of investors/traders over the last two days, myself included.

Before we get too deep into what happened, let’s look at the chart action.  Try to feel the emotion of the traders in this stock:


Keep in mind, I deal mainly with the price/momentum action, rather than the fundamentals or ‘reasons’ why.

First, we see a large impulse up caused by the initial major gap around July 23rd.  Traders may have rushed to buy this stock, thinking it was going to slip away from them.  In fact, the large open candlestick (along with volume) indicates a lot of traders DID buy thinking prices would surge.

But they did not. 

In fact, they fell in a downswing to a potential support zone at the rising 20 period moving average.

For me, this would have set up the “Impulse Buy” trade where my stop would be placed below the 20 period MA.  I suspect a lot of traders had the same logic I would have at this point.  In fact, we do see an inflection up at this point, and I suspect many traders felt the retracement was over, support was found at the recent price highs (along with the moving average), and that we would be going higher.

But we did not.

The proper location for most stops at that point was beneath the 20 period MA, and certainly beneath the 50 period MA as a last resort.  Certainly placing stops beneath the 50 period MA would be safe.

But they would not.

Around August 18th, price sliced below the daily 50 period exponential moving average and took out any (most) remaining stops that were placed beneath the anticipated area of support.  With the stops taken out, positions were taken out and traders who expected higher prices were forced to take a loss.

In fact, potential short-sellers may have entered at this area in expectation of a new downtrend forming, or support shattered, or some other reason.   Clearly price would continue to fall if it has broken the 20 and 50 period moving averages (they thought)…

But it did not.

In fact, price rallied -quite aggressively- and almost without pause for the next two months.  Perhaps traders who were stopped out chased price higher as price continued to slip away from them.  Either way, a nice uptrend occurred and price advanced from $75 to $95 with nary a downswing.  I’m sure traders expected some sort of retracement to come to let them gracefully enter the stock at a more favorable price.  Surely a retracement would come.

But it would not.

And so the retracement came around $95 with a large volatility move against the uptrend, which – actually – served as a choice entry point into the uptrend, though the chart was showing a “topping” or overextended sort of feeling.  A Momentum Divergence was also developing.

So Amazon released earnings and price gapped $5 and then rallied $5 more dollars (the large volatility bar on October 22nd), signaling a potential breakout trade entry, and causing many traders who sat on the sidelines to enter quite aggressively into the large move in anticipation of riches, validation, and satisfaction.  Traders who entered at these levels may have been somewhat uncomfortable, but few if any could have anticipated price would fall… especially so violently.  Surely they would be safe.

But they were not.

Excited traders – probably newer traders mostly – were so excited to wake up this morning to see instant riches and profits.

But they would not.

Instead, they woke up to an instant $10 slice in price which took prices to a maximum decline of $18 at the low price of the day.

Up.  Down.  Signal.  Failed Signal.  Large move up.  Large move down.

With thousands of other stocks out there that offer cleaner patterns and reduced risk, why don’t you trade some of them?  Remember, we trade for money, not excitement.  Amazon has been a nasty trading partner for most people over the last few months, encouraging trade entries in both directions and then ripping the heads of most of the traders who took these ‘easy’ signals.

Stay sane.  Stay safe.

If you are a new trader, it might be a good idea to avoid Amazon stock for a while.


Six Tips to Assess the Significance of Price Patterns

Oct 24, 2007: 2:18 AM CST

While there may be an unlimited number of potential price patterns in the market, most popular price patterns fall into two broad categories in relation to trends:  Reversal Patterns or Continuation Patterns.  Knowing more about specific patterns may help you determine which resolution in price is likely to occur.

Without delving too deep into the topic, popular reversal patterns include the “head and shoulders,” broadening formations, and rounding formations, while popular continuation patterns include rectangles, triangles, and flags/pennants.

Any of these patterns can turn into the other pattern (a reliably consistent reversal pattern may resolve to be a continuation pattern) at any given time and without warning.

Are there hard and fast rules you can apply quickly to assess the probabilities of resolution, or the significance of a given price pattern?

While these suggestions will not work all the time when you feel you have identified a pattern, they just might help you preserve capital or temper your expectations.

1.  The longer the pattern forms, the more likely it is to be a reversal pattern. 

2.  The shorter the pattern, the more likely it is to fail to conform to expectations. 

3.  The deeper (greater price fluctuation) the pattern, the more significant the likely price ejection from the pattern (due in part to the ‘measuring rule’ inherent in some patterns).

4.   The more accurately the expected volume pattern unfolds, the more reliable the pattern (examples:  Volume should contract during a triangle, flag, or pennant pattern.  Volume should be heavier on the left shoulder than the right shoulder.  Volume should confirm a pattern break-out.  etc)

5.  The longer (and more steep the angle) a trend has endured, the more likely a pattern is to be a reversal pattern.

6.  The more “perfect” (textbook) the pattern, the more likely it is to fail to conform to everyone’s expectations. 

Each pattern has its own set of expectations and rules, but these generally encompass most resolutions of price patterns.  There are a plethora of books or websites that can give you more information on specific patterns and the rules associated with them, but always keep in mind suggestion #6.  If everyone sees the same pattern and expects the same thing, the pattern will most likely fail due to the often sinister resolution of mass-expectations in the market.

Remember, patterns are expected to reflect psychological patterns of human participants, and observed patterns have been categorized, classified, and tested through the years.

While no pattern is 100% accurate, they can help add a new level of trade selection or analysis to your growing toolbox of trading ideas and tactics.


Dow and S&P find Strong Support

Oct 23, 2007: 7:13 PM CST

The Dow Jones Industrial Average, as well as the S&P 500 are showing a similar technical picture – that of strength in the face of ‘danger.’

Both major US Indexes inflected nicely off a solid level of support, drawn on both charts, which has both served as support and resistance over the last few months.  The longer a trendline exists, and the more frequently it is touched, the more relevant the trendline becomes.

Despite the bounce off support in these two indexes, the NASDAQ actually leads in relative strength, as it is completely erased the losses incurred by Friday’s ‘dramatic’ avalanche in prices across the most popular US Indexes.

The Dow:


The S&P 500:


I have drawn the major support level on both of these charts, and hinted over the weekend that price showed better odds of inflecting off recent support than breaking through it, even if the price action was a slight inflection.

Although the selling pressure and the most recent ‘down-swing’ in price was forceful, it was not sufficient to create a new momentum low in the lower panel oscillator, which is a bullish development.  The fact that the indexes managed to rally as much following a large volatility down move such as Friday is further evidence of underlying potential bullishness.

I mentioned this in the past, but it bears repeating.

WHY is the NASDAQ (heavily weighted with Technology Stocks) outperforming the S&P, Dow, and Russell 2000?

I need only show three charts and mention that ‘a rising tide lifts all boats’.   But does this ‘euhporic’ move contain breadth, or the support of a broad number of stocks, or just a handful?  That is the important question:

Apple (AAPL) traders reacted to strong earnings today:


Google (GOOG) rose in sympathy with Apple, combined with impressive earnings itself:


Strong stock Research in Motion (RIMM) could not be left behind with such a strong move in other technology stocks:


These three charts are even more impressive on the weekly charts.  You’ll need to use a logarithmic scale chart to view them properly.

Keep in mind that these stocks represent a narrow slice of the overall picture of what is happening in the broader stock market.  Other sectors and industries are in massive downtrends that are mirror images of these ‘impressive’ stocks (such as the housing and certain financial stocks).

Nevertheless, it is difficult to combat a rising market, especially one with such resilience as the current market is showing.

Be safe and trade well.


Links to Start the Week

Oct 21, 2007: 11:40 PM CST

I had an amazing trip to Chicago, and I intend to post more on that in the coming week, but first, here are some quick links to start your week:

Smart Money Tracker: “The Real Bull Market… Commodities!” Shows amazing charts on commodities and how they have appreciated.

Smart Money Tracker: “Trading Against the Odds” “The market is only interested in taking away your money as fast and as unfairly as possible.”

Chris Perruna: “How to Make Money Selling Short” (Includes links to other posts of his, as well as “Characteristics of Longer Term Shorts”)

Phil’s Stock World: “Hedging Your Way to Fun and Profit”

Phil’s Stock World: “How to Spot a Market Correction a Mile Away”

Trader Gav: “Tools for the Trader: A World Clock on your Desktop” Helpful if you trade FOREX or certain electronic futures contracts

Lauriston Letter: “Europeans Flee from Funds in Droves” A brief pararagph

TraderFeed: “…Other Ideas for a New Market Week”

Trading Goddes: “Time to Buy the Dips?” From Dogwood, three historical backtests are presented with astounding results after 4, 5, and 6 consecutive down-days

Trading Goddess: “Lots of Ways to Skin a Cat” From Bullish Jim, a discussion on three styles of trading with the question “Were do YOU fit in?”

Trading Goddess: “Where Might the NASDAQ Find Support?”

Trading Goddess: “Companies Reporting Earnings This Week”

Be careful out there!

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