a good read, as I still don't fully understand them either.
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In the last two issues of this newsletter we have explored the perspective of Western technical analysis on gaps. As we have seen, the swing trader should be able to identify four different types of gaps: area (common), breakaway, continuation (measuring) and exhaustion.
As you'll remember, an "area" gap occurs within a trading pattern such as a triangle, rectangle or rounding base. Typically, the "area" gap is of little significance. Since area gaps are often filled quickly, they conform to traditional wisdom that gaps are filled.
A "breakaway" gap is an entirely different matter. The "breakaway" gap ends a consolidation pattern and happens as prices break out. Often, a "breakaway" gap occurs on very large volume, as the supply available within the consolidation pattern has been consumed and bidders who want to enter the stock must pay up for it. A genuine "breakaway" gap will often not be filled for weeks or months (if ever).
A "continuation" gap occurs within a rapid straight-up movement. This type of gap is also known as a "measuring" gap because it usually occurs approximately halfway through the move. "Continuation" gaps may eventually be filled, but it should take some time to do so as the stock needs to first peak, reverse, and finally trend in the opposite direction.
An "exhaustion" gap occurs at the end of a price move. If there have been two or more gaps before it, then this kind of gap should be regarded very skeptically. A genuine "exhaustion" gap is filled within a few days to a week.
When a swing trader sees a gap, he or she should immediately ask, "What kind of gap am I witnessing?" Often it will take some time to come to a final conclusion. What seems to be a breakaway gap, for example, may over the next several weeks be filled and that filling may be an important catalyst to take swing-trading action in the opposite direction.
Candlestick theory, while less detailed about gaps, provides some important additional insights. Japanese theory does not distinguish between the types of gaps. Nor does it even use this term. Instead a gap is called a "window."
Whereas a great deal of emphasis in candlesticks is given to reversal patterns, a window is considered a continuation pattern. In other words, trading is highly probable to continue in the same direction after the window as it did before it.
In his groundbreaking work on candlesticks, author Steve Nison advises traders that they should typically trade "in the direction of the window." If a particular stock is declining when the window" occurs, then it is highly probable that the decline will continue. If the stock is rising when the window occurs, then it should continue to rally.
Once a window has occurred, it becomes an important support and resistance area. If the window occurred in a downtrend, then on any subsequent rally the upper end of the window should turn back prices. If the window was created in an uptrend, then when prices rally the bottom edge of the window should be the lowest point of decline. Further candle theory holds that the test of all open windows is likely. The key thing to examine is what happens on this test.
When the alert swing trader spots a window in a rising trend, he or she should expect, for a time, that the price will continue higher. Eventually, however, prices will reverse and will test the open window. On this test, prices should hold at the lower edge of the window, which is now important support. If, however, this support level is violated and selling pressure persists, then it is likely that the trend has reversed. The swing trader should now go short in the same way he or she would if a horizontal support level had been breached.
In a downtrend, the opposite is true. After the initial window, the decline should continue. Eventually resistance, which is at the upper edge of the window, should be tested. If buying pressure persists and is able to move prices beyond this upper window, then the swing trader should go long in the same way they would if a resistance level were overcome.
