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.

How to Profit from the Cup-and-Handle Chart Pattern

An interesting addition to the technical analysis tool set is the Cup-and-Handle chart pattern. It is very much like a bullish 'saucer' or 'rounding bottom' pattern, but provides additional points of entry.

There is no better way to learn about new stock chart patterns than to look at a practical example. I have chosen the 1 year bar chart pattern of Maharashtra Seamless, because it has made a classic, and clearly identifiable, cup-and-handle pattern:-

The stock made a previous high of Rs 328 in Aug '08 before continuing its bear market down move. It finally made a low of 112 in Mar '09, before embarking on a sharp rally with the rest of the market. In the process, it made a 'rounding bottom' bullish pattern.

The stock went all the way up to Rs 325 in Jun '09 - nearly tripling in value from its Mar '09 low. Not unexpectedly, it faced resistance near its previous high, and the first attempt on Jun 5 '09 failed to go past it. Three subsequent attempts on lower volumes also failed.

The stock then entered a corrective downward sloping channel that has taken it towards its 50 day EMA at Rs 250, where it is currently seeking support.

The horizontal line connecting the two tops of Aug '08 and Jun '09 forms the top rim of the 'cup' at Rs 328. The 'rounding bottom' pattern completes the body of the 'cup'. The downward sloping corrective channel is the 'handle' of the 'cup'.

The progress of the 'handle' needs to be closely observed, because it can provide clues to what might happen next. The depth of the cup is a move of Rs 216 (= Rs 328 - Rs 112).

The 'handle' can retrace between a third and a half of the 'cup' depth. That means a retracement of between Rs 72 (=Rs 216/3) and Rs 108 (=Rs 216/2). So, the correction of the 'handle' should stop in the price zone between Rs 256 (=Rs 328 - Rs 72) and Rs 220 (=Rs 328 - Rs 108).

On completion of this corrective move, the stock price should break up wards again. This provides three possible entry points - should you be interested in entering this stock.

1. The first, and riskiest, point of entry is any time the stock goes below Rs 256 - like it has done now. Why riskiest? Because the 'handle' can go below the Rs 220 level and possibly negate any up move for now.

(There are other reasons why you may want to enter now. Rs 250 is a support/resistance level - as can be observed from the chart patterns made in Jul '08 and Sep '08 (supports) and Oct '08 and May '09 (resistances). The 50 day EMA is another likely support. The RSI has entered oversold region.)

2. The second, and less risky, point of entry will be when the stock breaks out upwards from the downward sloping trend line of the 'handle' formation.

3. The third, and safest point of entry will be when the stock moves above the cup rim level of Rs 328.

The Cup-and-Handle stock chart pattern usually shows up as a continuation pattern in a bull phase. In this case, however, it has formed a bottoming pattern. (There are some other stocks that are also showing a similar formation. Curious readers may want to try and find out some of these stock charts, as an exercise.)

An inverse Cup-and-Handle can form in bear phases or at market tops - as a variation of the rounding-top bearish pattern.

Here are some questions for my readers. What do you think about the 'handle' formation? Why is it happening? Is it an 'accumulation' or a 'distribution' pattern? (Just use your common sense, and provide your answers in the 'Comments' link, or email me directly.)

Stock Chart Pattern - Tata Chemicals Ltd

The stock chart pattern of Tata Chemicals Ltd, another stalwart from the Tata stable, shows a nice breakout from a bullish consolidation pattern called an 'ascending triangle'.

The company manufacturers a wide array of products including chemicals like soda ash (used in detergents, water and effluent treatment, paper and glass making), sodium bicarbonate (used in pharma industry for making antacids, analgesics, toothpaste), fertilisers (like Urea, DAP, SSP), portland cement (manufactured using the solid wastes generated at its soda ash plant), and packaged salt.

Tata Chemicals has recently acquired a 36% stake in crop protection and pesticides company Rallis India from other Tata group companies, thereby taking its total stake in Rallis to 45%.

Steady growth, low debt/equity ratio, strong cash flows from operations, regular dividend payments make this an ideal 'boring' stock that can find a place in any long-term investor's portfolio.

Time for a look at the one year bar chart pattern of Tata Chemicals:-

The stock made a double top at 430 in Jan '08 and 440 in May '08, following which the bears really mauled the scrip. It bottomed at 100 in Mar '09. The bull rally took the stock to 266 in Jun '09 - retracing nearly 49% of the bear market fall.

A 3 months period of consolidation in an 'ascending triangle' was followed by an expected upward breakout - thanks to the deluge of FII money into the Indian stock markets this week. But bulls should not start a dance of joy yet.

The stock made a high of 275 and closed at 274 today. There is long-term resistance at the 270-280 zone. Also the 50% Fibonacci retracement level of the entire bear market fall is at 270. The stock has not cleared it strongly enough on higher volumes.

Also note the negative divergences from all four technical indicators. The RSI stopped short of entering the overbought zone. So did the slow stochastic. The MFI is barely above the 50% level. The MACD is marginally positive.

The next few days could be crucial for the stock, and for the market as a whole. If the FII inflows continue, new highs may be the order of each day's trade.

Bottomline? The stock chart of Tata Chemicals has given a mild breakout from a consolidation pattern. Existing investors should wait for the stock to clear 280 before adding more. Patient investors may wait for the next correction to enter.