I presented a bit of research a while ago that suggested the old adage “gaps must be filled” is a reasonably reoccurring pattern. I’d encourage readers to read this blog if they would like a primer on understanding gaps, and for some analysis on how often gaps occurring on daily charts are filled.
The daily candlestick chart below gives you a recent history of the S&P500 and the price gaps it has experienced since last December. You’ll note that the gaps I’ve highlighted on the chart have indeed been filled. Recall that “filling a gap” simply means that the market moves back to take out the excess movement the gap represented. Again, I strongly recommend you read the blog noted above, and I might even be so bold as to suggest you read the section within my book Sideways that covers the subject. The book also covers “turnaround” candlesticks, which I’ve noted on the chart. Such candlesticks enhance the potential for a gap to be filled.
The S&P 500 gapped up as it hit its all-time high price point on Friday of last week. Immediately following Fridays gap up, yesterday (Monday June 20) saw a pullback from the high. Will this be the beginning of a retracement back to the early price point of last week – i.e. will the gap be filled? My guess is yes, it will be. Momentum indicators (RSI and stochastics – not shown on this chart) are overbought. The price action that fills gaps need not be immediate, so you might have to wait a few days before the retracement is complete. Were the S&P500 to illustrate a turning point candlestick as noted on a couple of the gaps in this chart – that would strengthen the case for a bigger pullback than just the filling of the gap.
Introducing business students to Technical Analysis
I’m off to speak to Georgian College business students today to de-program their minds on the buy and hold / can’t time the market myths. I’ll be lecturing on the basics of Technical Analysis.
Do you know of a student taking business, finance or commerce in college or university in Ontario? Forward this blog to them and encourage them to pass it along to a teacher or professor at their school. I welcome the opportunity to introduce these students to Technical Analysis. I have done guest lectures for Georgian College, Laurentian University and Ryerson University in the past, and I’m only too happy to do more of this type of work in the future – at no cost to the school, of course.
Since you are on the topic of Gaps, I would like to know how to protect ourselves (“reduce risk” as you say) from them: especially the ones on the downside. And secondly, for curiosity, how are they created: is somebody able to make trades while my trading account is closed for the night?
Here is a real life example that just happened to me:
The trend is your friend until the trend reverses, right?
We don’t know exactly when it will reverse…
To minimize risk to the downside, on Monday, I put a stop loss order at $7.80 and the stock was at $8.00.
Next trading day, there is a “gap down” and the stock price dropped right down and is now worth $7.
I look at my trading account Tuesday morning and my stop loss order is still there… unfulfilled.
Just lost of whole bunch of money. Sad sad day.
What do you use to protect your investments against occasional Gap downs?
Thanks a lot Keith!
Luc–this is an excellent question.
I dont use “real” stop loss orders for the reason that you talk about. I use mental stops. A couple of things-
1- you put in a limit stop. The order couldnt be filled at your exact price. If you use a stop loss, give the trader some discretion so if the market moves super fast he can take a few other bids on the way down. so you could have said “sell on stop at $7.80, limit $7.50” or something like that
2 -the pros see your stop order. If the stock starts to go down, but they feel its not going to stay down, they use your stop loss to buy your stock. They bid at your stop price, and try to snap it from you–then happily profit as it rebounds.
For these reasons, I use support lines, and put mental stop losses on the stock. I can act on the price but not get whipped out (as in example 2) or miss a trade (as in example 1).