Gaps and the NASDAQ

On occasion, gaps appear in price charts. These arise almost exclusively in daily and intra-day charts. There are a number of things that cause gaps to emerge in individual stocks, such as news or earnings announcements (positive or negative) coming out after a day's trading has ended, which causes a new equilibrium price that is different enough to gap up or down from the prior day's trading range. Actually, there are several different types of gaps. There is a good article about them at Chart School in StockCharts.com, and another about how to trade gaps on Investopdia.

The reason for this blog post is that the NASDAQ has seen several gaps over the past few weeks. The chart below (click to enlarge) shows this. One thing that many of us who follow the market utilize is the tendency for gaps to be filled. How long it takes for this to occur, however, can vary widely, and it depends on the type of gap (see the articles above). Some, breakaway gaps, for example, can take quite a while to fill, if they even end up being filled. At the other extreme is exhaustion gaps, which are very likely to fill (see articles). The gaps in the NASDAQ chart are merely "plain vanilla" or standard gaps. Note an interesting pattern for the last two gaps: they both filled on the third day (almost sounds biblical!). DO NOT make anything of this, it is merely a coincidence.

I do want to point out a trading strategy related to the typical gap. Since gaps tend to eventually fill (again, depending on the type), some traders will essentially place trades that presuppose this. In other words, they trade in the opposite direction of the gap. This is called fading the gap. While I have used this on a number of occasions in the past, I did so with added criteria. So, according to this trading philosophy, if a down gap emerges, go long in anticipation that price will rise and fill the gap.

How likely is it that a gap will be filled in a reasonable time period? Use technical indicators to make this determination. If there is an up gap, for example, and price moves fairly close to resistance and/or the RSI shows an overbought reading, the odds of gap filling are in your favor. It might take longer than you are comfortable with, however. This has a bearing when traders are using options which have a time decay factor that lowers their prices each day as you wait for the filling to occur. Similarly, if a gap down occurs, moving price close to support and/or the RSI is at oversold readings, the likelihood of filling the gap are fairly good. As always, identify either bullish or bearish divergences improves the odds of your being correct even more.

When I originally planned to write this blog, another pattern existed that has now ended. The most likely support for the NASDAQ at present is its 50-day moving average. If a gap emerges that is not very far from the 50-day, and the RSI is at or near an overbought reading, the odds that the gap will be filled as part of a retest of support (at the 50-day moving average) are very favorable.

Let me end this post by transcending exclusive reliance on technical criteria. If you are attempting to determine where price will eventually go, create a price forecast using economic criteria. Identify the primary explanatory variables that will influence price over your time period of interest, then predict what each of them will do. Once you have done this, determine the dominant changes and along with that, your price forecast. For the market as a whole, price depends on interest rates and profit expectations. You then find several variables for each of those factors. At the firm or industry level, the choice of factors can differ. For example, interest rates might not be very influential (ex: consumer staples), or how cyclical the firm or its industry are must be accounted for. That leads to your identifying additional factors to use in your forecast.

Hopefully, it might have crossed your mind that it is also highly useful to incorporate intermarket relationships into this type of analysis. What is the commodity market signaling? How about currencies? The bond market? Put all of this together (as you must for the course paper) and you have a very educated guess about the overall market's direction.