A gap that occurs well after the beginning of a trend reversal, where stochastic are still
in the midrange of an uptrend, has different implications. How do you distinguish
whether a gap is a potential measuring gap? Evaluate where the stochastic are in the
trend. If they are still relatively low, the trend has more room to create another gap before
getting to the overbought area. Note in the CTX chart, Figure 9 – Centex, how the trend
started with a small gap up. The next few days, another gap forms, in the midrange of this
trend. The bears could not push prices back down through that gap over the next few
Figure 9 – Centex
Eventually the bulls gapped up the price again. Notice that the beginning of the trend up
to the first gap [B] is about the same price movement as the move after the second gap to
the top of the trend [A]. This simple measurement gives the gaps their name. The telling
ingredient is the fact that the bears could not push prices back down through the first
measuring gap. That factor gives the bulls renewed confidence and they step back in. The
next day they gap it up again due to not being afraid of the bear camp.
Gaps At The Top
The gap that appears at the top of a trend is the one that provides the ominous
information. Remembering the mental state of most investors, the enthusiasm builds as
the trend continues over a period of time. Each day the price continues up, the more
investors become convinced that the price is going to go through the roof. The “talking
heads” on the financial stations start to show their prowess. They come up with a
multitude of reasons why the price had already moved and will continue to move into the
With all this enthusiasm around, the stock price gaps up. Unfortunately, this is usually the
top. Fortunately, Candlestick investors recognize that. They can put on exit strategies that
will capture a good portion of the price move at the top. Consider the different
possibilities that can happen when witnessing the gap up at the top of a sustained uptrend.
Most of the time the gap will represent the exhaustion of the trend, thus called an
Exhaustion Gap. Or it could be the start of a Three Rising Windows formation. Or big
news, a buyout or a huge contract is about to be announced.
What are the best ways to participate in the new potential, if there is any, at the same time
knowing that the probabilities are that the top is in? A few simple stop-loss procedures
can allow you to comfortably let the price move and benefit from the maximum potential.
Hopefully, in the description of the gaps occurring at the exuberance of an extended
trend, you have already experienced a substantial gain in the position. Any gap up is
adding to an already big gain. Probabilities dictate that this is the top. Possibilities could
include more upside gains.
Upon a slight to medium gap up, the Candlestick investor should put their stop at the
close of the previous day. The thinking being that if the price gapped up, indicating that
the top is in, and the price came back down through the close of the previous day, the
buying was not sustained. If so, the stop closed the position at the level of the highest
close in that trend.
Look at Figure 10 – NXTP, Nextel Partners Inc. If you had bought the stock the day after
the Harami signal, showing that the selling had stopped, the open may not have been the
strength wanted to show that the buyers were stepping in. After the price opened lower
the next day, not showing resumed buying, a good spot to put the “buy stop” would be at
the closing price of the previous day. The thinking being that if the price, after opening
lower, came up through the closing price of the previous day, then the buyers were still
around. Buying price = $4.50.
After a few weeks, the price starts to accelerate and finally they gap it up. News was
probably looking very rosy at this point. Now the Candlestick investor is prepared.
Knowing that a gap up at the top indicates that the top is near, they can implement
strategies to maximize profits. Most investors will know that their position is up almost
100% in three weeks. That is not the type of move that will be missed by most. Upon
seeing the bigger price days and volume picking up, the Candlestick investor will be
ready for any sell signals that appear.
When the gap open appears, a number of strategies can be put in place. First, a stop loss
can be put at the closing price of the previous day. If prices start falling off immediately
and come down through the previous day’s close, then the bears have taken control. You
are out at the high close of the uptrend. In this case, as the price moves up, it would be
safe to put a stop at the open price.
Figure 10 – Nextel Partners Inc.
A fundamental change might be in progress. The same rationale as putting a stop loss at
the previous day’s open, if the price comes back down to and/or through that level, the
sellers probably have taken over control. Otherwise, if the stock price continues higher, it
may stay in a strong spike move for the next few days. Knowing that the stochastics are
now well into the overbought area, and the price was running up after a gap, selling one
half of the position would be a prudent move. Probabilities say that this is near the top.
There is always the low percentage possibility that new dynamics are coming into the
stock price, an announcement of a new huge contract or a possible buyout offer,
something new and different from the dynamic that ran the price up to these levels in the
first place. A surge of buying may create a “Three Rising Windows” pattern, moving
prices to much higher levels. The probabilities of this occurring at the top of a trend are
very small but feasible. Moving the stop losses up to each close or next day’s open price
maximizes the potential profits from that trade.
As seen in NXTP, a Shooting Star formed, definitely a sell signal. If the price opened
lower the next day, the position should be liquidated immediately. That is what the
Shooting Star is telling you, that the sellers are showing up. The next day opened higher
and stayed up all day. Things still look good. However a Hanging Man formation appears
the next day. This is where the Candlestick investor should be thinking, “a Shooting Star,
a sell signal, now a Hanging Man, another sell signal, be ready to get out.” The next day
after the Hanging Man, a lower open should have instigated the liquidation of any
remaining position. At worst, the average selling price should have been in the $8.10
area. The gap was the alert signal that positions should be liquidated. This trade produced
an 80% return over three weeks. Now go find another bottom signal.
Figure 11 – Omnivision Technologies Inc.
Figure 11 – OMVI, Omnivision Technologies Inc. demonstrates a gap open at the top
with absolutely no follow through. This is when having a stop at the previous day’s close
will be the best exit. Whether the position was established at the breakout gap or the Tri-
Star pattern, the profits were substantial. Being prepared for the gap up was the profit
If the gap up is substantial, after a long uptrend, it might be prudent to liquidate one half
of the position immediately. The remaining position would have a stop placed at the
previous day’s close. If the price pulled back to the previous close, again it would be
apparent that the sellers had stepped in after the gap up. The method locked in a price
above the highest closing price of the trend.
Illustrated in Figure 12 – MGAM, Multimedia Games Inc., the end of the up move was
foretold by a large green candle forming after a run up, then a gap up follows. This
should have alerted Candlestick investors to start profit taking. It produced a good 33%
profit in a just over a week. Now go find a low risk bottoming trade again.
Figure 12 – Multimedia Games Inc.
If the gap is up substantially, and it continues higher, put the stop at the open price level.
On any of the scenarios described, the price moving back to the stops would more than
likely create signals that warranted liquidating the trade, forming Shooting Stars, Dark
Clouds, Meeting Lines or Bearish Engulfing patterns. In any case, sellers were making
themselves known. It is time to take profits in a high-risk area and find low-risk buy
signals at the bottom of a trend.