Analysis of gaps in stock chart patterns

Analysis of gaps require an understanding of different types of gaps that occur in the bar chart pattern of a stock or index. An area of no trade, or a 'gap', occurs when the low of a particular period, be it a day or week or month or year, is higher than either the previous or the next period's high.

Gaps in daily charts is quite common. Weekly gaps are less frequent. Monthly and yearly gaps are the least frequent.

There are four types of gaps:-

• Common gaps occur in a rectangular or triangular consolidation area
• Breakaway gaps occur at the beginning of an up or down move
• Runaway or measuring gaps develop at the middle of a move
• Exhaustion gaps happen at the end of a move.

Most gaps, particularly common gaps, get 'filled' quite quickly. But some gaps can remain unfilled for prolonged periods - weeks and months. Even years. On rare occasions, they may not get filled at all. As a general rule, gaps do get completely or partially filled and the previous trend resumes.

An interesting chart pattern called an 'island reversal' occurs when an area of trading is separated by an upward gap at one end and a downward gap at the other. Such a trend reversal pattern happens at the top or bottom of a trend.

Let us look at the 1 year daily bar chart pattern of the BSE Sensex index to try and identify and analyse the gaps:-

Notice several 'common' gaps during the rectangular consolidation of the Sensex during Oct '08 to April '09 - all of which got filled. After the breakout from the larger rectangular consolidation in Apr '09, the chart pattern entered a smaller rectangular consolidation, called a 'flag'. (A 'flag' is a continuation pattern.)

A 'breakaway' gap occurred at the end of Apr '09 followed by another 'flag' pattern. The huge 1200 point gap then developed, post election results in May '09. This was partially filled during the correction in Jul '09.

Ever since, the Sensex chart pattern has been in an up trend, defying all concerns like deficient monsoon, rampant rise in prices of common staples, poor exports and low volumes of trade. Observe several common gaps during the sideways consolidation move post-election from May '09 till date.

An important question: Is the 1200 point post-election gap a runaway (or measuring) gap, or is it an exhaustion gap?

If it is a measuring gap, then it is supposed to occur at the midway point of the bull rally. Since the gap is between 12300 and 13500, half of the gap, i.e. 600 points should be added to the lower edge of the gap, to give a level of 12900 as the midpoint of the rise from the low of 8000. The rise to the midpoint is (12900 - 8000 =) 4900 points.

This gives an approximate target of (12900 + 4900 =) 17800 for the Sensex. Why approximate? Because technical analysis is not a science but an art. It deals with indications and possibilities, and is imperfect.

Why did I raise the question about the type of gap? The part filling of the gap indicates that it should be a measuring gap. The resumption of the up move confirms it.

A look at the 2 years weekly bar chart pattern of the BSE Sensex throws some interesting contra-indications that I have discussed in earlier posts:-

In the longer term weekly chart, no common gaps are appearing during the rectangular consolidation period from Oct '08 to Apr '09. But the breakaway gap at the end of Apr '09 and the huge post-election gap in May '09 are clearly visible.

Observe that after the gap, a bearish 'broadening top' is being formed in the BSE Sensex chart pattern. Higher tops and lower bottoms indicate that neither the bulls nor the bears are in complete control. An eventual break downwards from this pattern is a possibility.

Also note that the entire trading above the gap could turn into a bearish 'island reversal', should the Sensex chart move down with a gap below the 13200 level. This hasn't happened, or may never happen, but the possibility remains open. In which case, the gap will be an 'exhaustion gap'.

Technical analysis is never a 'sure shot', so trade gaps with caution. An upward or downward break out with a gap is likely to be more valid than a break out without a gap. Upward breakouts should be accompanied by higher volumes. Downward break outs do not require volume support.