Testing Upside Gaps

Gaps act like previous highs and lows: When a stock or index gaps up, then the gap itself turns into a support level for any pullback. Previous examples have shown trades that were triggered by a test of a previous high or low. Tests of gaps also trigger trades. Tests of gaps on lighter volume imply that the issue does not have enough energy to get through the gap; instead, the gap becomes support and a bullish signal is triggered.

Tsst of gap on tiaftler vo'jne Arte 1 ck»t «tcvt gap tew" buy signal

FIGURE 4.24 Gap Test Rules Show a Buy Signal Triggered by Lighter Volume on a Gap Test and Close above the Gap Low

Tsst of gap on tiaftler vo'jne Arte 1 ck»t «tcvt gap tew" buy signal

FIGURE 4.24 Gap Test Rules Show a Buy Signal Triggered by Lighter Volume on a Gap Test and Close above the Gap Low

In Figure 4.24 we have a line chart of stock ABC. A gap formed from $49 to $50 on trading volume of 100 million shares. ABC then pulls back to $49.50 on volume of 80 million shares, or 20 percent less volume than when the gap was formed. A close above the gap at $50 triggers the buy signal.

Here is the rule for buy signal on gaps ("Gap Test"):

Tests of gaps on a 10 percent or greater decrease in volume and a close above the gap low triggers a buy signal. The lighter the volume on the test of the gap the stronger the buy signal.

I have also found that the gap does not need to close completely for this trade set up to be successful. In the example of stock ABC, notice that the pullback to fill the gap came in at $49.50 and not all the way back to $49 to close the gap. In my studies, I have concluded that an issue only needs to break an area of the gap to have a bullish setup. Therefore, on the current example, even a pullback in stock ABC to $49.99 would have been sufficient to trigger a buy signal.

A gap may sometimes be tested more than once. As long as volume on the test of the gap declines by 10 percent or more, then the gap will hold, and the market should move higher. It is important to remember that a stronger signal is generated when volume is very light on the test of the gap. This condition shows that energy is very weak as the market tries to push through the gap level, and this, in turn, is very bullish for the issue.

If a trader has a choice between two issues that are each testing gaps levels, the trader should take the issue where volume shrinkage is the highest against the gap level as that will be the stronger setup. Shrinkage in volume of 10 percent on a test of a gap level is the minimum requirement in order to realize a positive result. Less than 10 percent shrinkage in volume on the gap test will lower the chances of a successful trade.

Figure 4.25 is a candlestick chart of Google, Inc. (GOOG). In late December 2006, GOOG tested the gap level from late October of $430 to $454 on nearly 50 percent lighter volume and then closed above the gap level. This condition triggered the buy signal. Notice that there were

FIGURE 4.25 Gap Test in Google (GOOG) in December 2006 on Lighter Volume Triggered a Buy Signal Source: Chart courtesy of DecisionPoint.com.

two tests of the gap level in late December, and both times buy signals were triggered. The second test in late December of the October gap was the stronger buy signal because the volume was much lighter than the first test (which was the day before). The second test showed there was less force to the downside and a more bullish condition existed. This buy signal at the $454 range had an upside target to the previous high of $513 range, and that target was achieved.

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