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This month’s Trade Secret has been submitted by Charles K. Langford, Vice-President, Portfolio Overlay Management, at The New Providence Portfolio Management Ltd. Mr. Langford has been giving seminars and lectures on risk management of exchange-traded and over-the-counter stocks, bonds and derivative instruments since 1975. He holds an MA from McGill University and is also a Fellow of Canadian Securities Institute. He has published hundreds of articles and a dozen of books on options strategies, technical analysis, risk management of long and short-term interest rates and portfolio management. He publishes a daily Web-based technical analysis bulletin dedicated to ETFs (exchange-traded funds) and futures contracts. Mr. Langford’s latest book, which describes a method for detecting new price trends, will be published by Les Éditions Quebecor in January 2006.

How to Read Gaps: An Introduction


Back in the second century AD, the Greek philosopher Epictetus taught that the facts of our lives can be divided in two categories: those under our control and those not. The things we do not control include property (he had been a slave) and our physical body (at the time the majority of the diseases were incurable). Had exchanges existed in his day, Epictetus would surely have added gaps to the things not under our control.

A gap is indeed a strange beast: a vacuum in the flow of prices. It is as though the water of the Saint Lawrence River suddenly stopped running near Montreal , only to resume again at Quebec City .

There are two main categories of gaps: those that are created between two sessions and those that take place in the same session. This last category concerns mainly the day traders and, because they are a small group, I will ignore it in this introduction.

A gap is simply a range of prices with no associated transactions. In other words, the prices do not actually exist. For example, a stock closed yesterday’s session at $50 but opened this morning at $52 and continued to rise until today’s close. Thus, $52 is the day’s low and the (bullish) gap between the previous close and today’s low is $2.

A gap between two sessions occurs when the opening price is higher (bullish gap) or lower (bearish gap) than the previous close and the difference is not made up until the current day’s close. This is illustrated in Figures 1, 2 and 3.

The cause of gaps is twofold. First, a gap is created by unexpected news. The news is disclosed when the exchange is closed, meaning it cannot influence the price immediately but will do so at the next open. Most gaps would not happen if exchanges were open 24 hours a day, seven days a week. Second, the news can give rise to another development. There are stocks that are turbulent (“volatile” in the jargon of the exchange) by nature and that consequently like gaps. In short, unexpected news can create a gap and the nature of the stock can amplify it.

We distinguish two types of between-session gaps based on size: primary and secondary (see Figures 1 and 2). Primary gaps are illustrated in Figure 2. A bearish gap is shown on the left, a bullish one on the right.

Applying the prices in our example to the right-hand diagram in Figure 2, we can say that the low (L = $52) of the second session (S2) is higher than both the close (C) and the high (H = $50) of the preceding session (S1). This is a primary gap.

An example of a secondary gap can be seen in the right-hand diagram of Figure 1. For example, the close (C) of the first session (S1) is $50. The next day (S2) the price opens at $52 and falls to a point lower than the first session’s high (H) but stops at a price higher than the close; then it goes up again. In such cases, we always have a gap, although one smaller than a primary gap.

So, the difference between a primary and a secondary gap is its visibility. In price charts, a primary gap stands out, while a minor gap is not so obvious. It is a significant difference, because more visible the gap is, the more it draws investors’ attention and the greater its influence will be.

Why, then, are gaps important?

A gap acts like a magnet: it attracts investors to trade at prices not yet negotiated.

It is obvious that, to act as a magnet, a gap must be visible and, to exert its power, it must be recent.

Figure 1

Figure 3 is the price chart of a stock that likes gaps, especially primary gaps, namely BVF (in technical analysis, the symbol is sufficient to identify the stock; other data are superfluous).

Figure 3
(This type of graph is available on the DDweb platform.)

Primary gap A, in January, got filled by the prices of March 4. Extended primary gap B got filled in several sessions and was fully covered on March 23.
Short primary gap C was covered on August 4.
Extended primary gap D got filled on May 27.
Gaps E, F and G had not been filled as at the date of the graph (September 2).

Gaps are also categorized on the basis of price behaviour. Gaps appear either in congestion areas (i.e. when the stock repeats the same trading range two or more times) or in trends, where there are three types of gaps because a trend has a birth, a life and a death. Gaps in congestion areas are called common gaps and usually get filled quickly. Gaps at the start of a trend are called breakaway gaps; these often do not get filled and, when they do, it is usually later than for the other types of gap. Gaps during the life of a trend are called runaway gaps; sometimes they get filled quickly. Gaps at the end of a trend are exhaustion gaps; although they can get filled quickly by volatile price behaviour, in covering the gap the price often generates another gap.

Referring to the BVF bar chart, we could say:
A is a breakaway gap, because it happens at the beginning of a trend.
B is a common gap, because it takes place in a large congestion area, between two tops (February 8 and March 24) and the March 4 bottom.
C is a breakaway gap, because it is at the beginning of downtrend.
D is a runaway gap.
E is a breakaway gap at the beginning of the uptrend.
F is a runaway gap.
G is probably an exhaustion gap.

This classification seems to give us some control over gaps. However, such classifications can often be applied only after the fact, which does nothing to help us make a profit.

So, how can an investors profit from a gap? By keeping in mind that, sooner or later, it will probably get filled and placing orders at prices near the point at which the gap will be covered.

While technical analysis is excellent for identifying the starting point of a trend, it is less able to predict the price at which the trend will end. On the other hand, an unfilled gap is a tool that can be used to establish a final or intermediate target.

Investors who are made anxious by gaps should probably give up individual stocks, especially volatile stocks, and replace them by stock indices, such as the Canadian XIU (the S&P/TSE60 Index) and the American DIA (the Dow-Jones Index of Industrials). It is unusual for conservative indexes to have gaps, because they are averages of many stocks and their volatility is lower than that of their components.

September 5, 2005 Charles K. Langford - NPPM Ltd.

Previous Newsletters

• September 2005 - Using Bollinger Bands
• August 2005 - The MACD – An Introduction
• July 2005 - How can you spot changes in trends ahead of the crowd?
• June 2005 - An application of the Langford forecasting method
• May 2005 - In-The-Money, At-The-Money or Out-Of-The-Money Calls
• April 2005 - Synthetic Option Strategies