Breakouts and Gaps

When price levels move above resistance or below support, the change is significant. However, a momentary breakout can also retreat back into the previous trading range, meaning that the breakout fails. When a breakout is accompanied by a gap, the chances of its reversing and filling are quite high. It's all a matter of momentum. If prices move too high too fast, you have to expect a reversal.

Key Point

Both breakouts and gaps can be very meaningful. But when they occur together, smart traders know they have to pay close attention to price movement.

When the breakout moves above resistance, many changes can occur.
For example, in Figure below, Toll Brothers stock broke through resistance; if you began to analyze the price pattern based on the previously mentioned concept of old resistance becoming new support, that level was tested almost immediately.

[caption id="attachment_12762" align="aligncenter" width="550"]Breakout above resistance. Breakout above resistance.[/caption]

The price fell after this, so that the breakout failed. In this case, you would not have needed to wait very long to discover that prices were not necessarily on the move, and that the breakout lasted only a few sessions.

The same conditions prevail when a breakout takes price down below support. For example, ExxonMobil experienced a bottom-side breakout in its three-month chart, as shown in Figure below.

[caption id="attachment_12763" align="aligncenter" width="550"]Breakout below support. Breakout below support.[/caption]

This breakout held. After a sideways movement of considerable time, the breakout was followed by a fairly strong downward price trend with no reversal or retesting of the previous level.

Breakouts are revealing, especially when they occur as part of a gapping action. Several gaps were present on Eastman Kodak's chart, including the first one that occurred along with a breakout above resistance, as shown in Figure below.

[caption id="attachment_12764" align="aligncenter" width="550"]Gaps Gaps[/caption]

This first gap is not obvious because there was no space in between sessions. However, if you see that the first of the two days was black, meaning it closed at the bottom of the rectangle, then the opening of the next day gapped above that level. This set off what turned out to be a very strong breakout and uptrend.

Key Point

Not all gaps are visible. Detailed analysis reveals that some of the most important gapping patterns involve gaps between up and down days, and these may be shielded because candlestick real bodies overlap.
The second gap was also subtle. The small distance between the first day's close and the second day's open gave a brief upward indicator. But as the third, strong gap proved, the momentum was not strong enough for this uptrend to last very long. Prices fell quickly, ending up within the range below the original resistance level at the beginning of the chart.

Gaps occur often in most charts. The gap that simply occurs as a matter of normal trading but without any special signal attached is called a common gap.

Gaps are important in many different ways. The breakaway gap can be subtle and small like the one in the previous chart, or it can be very strong and wide. Its characteristic is that it moves price away from the established trading range.

When a rally takes off strongly, it is also likely to exhaust more quickly. This is not always the case, but on average you may expect to see a quick rally turn suddenly. This is especially true when the trend is accompanied by the runaway gap pattern. This is a recurring series of gaps, including consecutive gaps in two or more sessions. This is troubling because of the singular movement without slowing down, and the gapping action may drive price levels much higher or lower than the level justified by actual buyer or seller interest.

Key Point

The runaway gap pattern can be encouraging if prices are going in the direction you want. However, they also mean that the trend is likely to lose momentum quickly and reverse more strongly than trends without these gaps.
Another kind of gap is called the exhaustion gap, and this is found at the end of a trend. After a particularly strong trend with a pattern of runaway gaps, exhaustion gaps are more likelyv than in other trends, and may be seen right as the price direction has turned.

The many types of popular price patterns are valuable not so much by themselves but as part of a greater pattern and assuming that two or more indicators confirm the apparent significance of current price positions.

Beyond price patterns tracked over a series of sessions, more advanced indicators provide additional confirmation (or contradiction) and provide greater insight. These enable you to anticipate reversals before most traders know they are going to occur.
By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2016. Content published with author's permission.

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