Showing price patterns

Understanding price gaps

Price gaps are very common in the financial markets, and occur on charts when no overlap exists between consecutive period highs and lows. For instance, if XYZ stock's high is 81 and its low is 80 on a given day, and then the next day it opens higher than 81 — let's say 83 — and trades in a range between 82 and 84, a gap with no trading exists between 81 and 82. That stock gapped higher and never closed the gap. If the stock had opened much lower — 77 or 78, for example — and never reached the previous day's low, it would've gapped lower.

So what causes price gaps? These gaps are usually the result of news about a certain security being released outside of market hours. It's not uncommon: Most companies release their quarterly earnings or other big news either after the market closes or before it opens. The market adjustment to that news causes price gaps.

Also, a gap may occur on specific stocks just because they're moving up or down due to a gap in the overall market. This may occur due to a release of some economic news before the market opens or possibly due to a macro event such as a terrorist attack.

You should remember that gaps always get filled when the high to low price action of a future day covers the price range where no trades occurred. But you can't always tell when gaps will be filled. When the dot.com bubble was building, some Internet stocks had several price gaps on their way up to stratospheric valuations. These gaps were eventually filled, but anyone trying to short these stocks for the gap being filled would've ended up in the poorhouse before any gap filling took place. (Take a look at the "Selling short, in short" sidebar for more information on shorting.)

3. After this shift from bullish to neutral price action, the following day is a down day.

The third day is a winning day for the bears!

Figure 2-4:

A common candlestick sell pattern.

Bullish Day

Even Day

Bearish Day

Once again, a trader who studies candlestick charts and patterns can easily spot this change. Such a momentum shift is useful to someone who owns a security and is considering selling or a trader who has the ability to sell short. (See the sidebar "Selling short, in short" in this chapter for more information.)

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