Technical analysis exists because of two core ideas; the existence of traders who follow chart patterns and use technical analysis tools, and secondly because certain concepts are reflective of investor psychology. The simplest example of investor psychology is where investors set limit sells at round numbers, which causes resistance to show on the chart. This tutorial will look at what chart gaps are, different types of gap and the psychology behind each that allows you to trade the patterns that follow thereafter.
What is a Chart Gap?
First and foremost, to be able to see a chart gap we need to employ the use of a specific type of chart; a candlestick chart. There are other chart types that work, but this tutorial will look at the candlestick version. I'll look at different types of chart in a future tutorial, but for reference it looks like the chart type shown on the right hand side of the image below. Your chart platform should also have it labelled.
The above two graphs show the price movement for Amphion Innovations (LSE:AMP), a small company listed in the UK. The chart on the left hand side is a line chart and shows intra-day movements between June 1st 2015 and June 6th 2015, whereas the right hand graph is the candlestick chart and shows the daily movements for Amphion between mid-April and June 6th 2015.
The important points to note about a candlestick chart for this tutorial are as follows:
- The bulk of the candle is shown as either the white or black bar. The bar is white if the share price on that day was higher at the close than at the open. The bar is black if the share price on that day was lower at the close than at the open. For example, if the share price opens at 5p and closes at 6p then it has risen since the open, and the bar will be white.
- The vertical line extending out of the bar shows the high and low prices for the day. These are known as the upper and lower candle wicks.
If you look on the right hand graph you can see a massive gap between the last two bars; this is a chart gap. A gap is simply where two candles/wicks do not cross and if you think about it, this will occur if there is a big move in a stock when it opens for trading.
The primary reason for this will be some sort of news that leads to the share price being 'gapped up' or 'gapped down' at the open. Indeed, we can clearly see this on the intra-day chart on the left. Right at the open on June 5th 2015, we can see that Amphion dropped from 8.75p to about 6.5p. What was the significant news that drove this? Amphion announced, at 7am on June 5th, that it had completed a placing at 5.25p, which was a severe discount at the time. This was negative news at face value hence the stock was gapped down at 8am when the market opened. We can see that on the line chart.
That sums up what a gap is, but it's fundamental to being able to interpret the investor psychology side. It's an immediate movement of the share price, at the open, that is a significant change from the previous close price. It is almost always caused by significant news that is released before the markets have opened.
Different Types of Chart Gap
For each of these gap types we will look at their typical pattern and then how you could trade the aftermath of these gaps, looking closely at the psychology involved. As before, the absolutely pivotal point to remember for each of these is that the gaps are often based off unexpected news (or a particularly large market-wide move, which is also exogenous and unexpected). This is important when we consider the psychology.
Note that I will refer to the typical move; ultimately this will not be replicated in every case.
The Common Gap: This is a gap that occurs between trading days without major news. The size of the gap rarely exceeds 2% and is often found as part of a general horizontal trading. It has no major importance of psychological read-through so we can leave this type of gap.