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| HOLE IN THE WALL |
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When planning new gapper trades, the Hole in the Wall should be your first stop. Edwards and Magee briefly mentioned them in their classic Technical Analysis of Stock Trends. In the section on trend theory, they discuss an Island Reversal's important second gap (the one that "completes" the Island). E/M refer to this move as a counter trend Breakaway gap although it doesn't follow the rules they themselves provide on the subject.
While the Hole can mimic a Breakaway gap, it also contains unique properties. The counter trend shock triggers predictable price movement the trader can exploit for quick swing long entries and short sales.
E/M identified gaps by their physical momentum properties and forecasting value. Breakaway, Continuation and Exhaustion gaps defined clear focal points of price action that were seen over and over again in dynamically trending issues. But beyond these few formations, the authors dismissed the balance of gapping throughout the market universe as having no forecasting value. This is simply not true.
While classic definitions were once adequate, their work on the subject now lacks depth for the active trader. And unfortunately, the current trade dogma asserts that everything there is to know about gaps has been written.
The forecasting value of gap behavior goes well beyond the E/M world. The study of Gap Echos alone yields tremendous new insight on entry and exit strategies. And characteristic gaps as significant as the Big Three have always existed for the trader to identify and use. |
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| Hole in the Wall |
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Sharp, downward gap following the conclusion of a rally. The Hole ends the preceding trend and may trigger profitable trading conditions:
1. Breakaway gap signaling the start of a dynamic trend in the opposite direction.
2. Counter trend move flagging sideways swing trade opportunities.
This price shock occurs in all time frames and can be used for both day trading and position trading. In either case, seek short sales and brief long side swing entries until the Gap is closed. |
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| Focus on Day Trading |
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Hole-in-the-Walls can trigger excellent day trades. Occasionally price may even undergo a significant gap intraday although this is rare. More frequently, the gap will appear at the open of a multiple day intraday chart. This gap may or may not eventually signal a Hole in the larger daily chart. But the day trader's advantage is that confirmation within the shorter time frame comes much more quickly.
The best trades may come after waiting for the short-term bottom, as with the larger Hole trade. Odds are very strong the gap will not close if it remains open after the first hour of the gap day. |
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| Old Traders Tales |
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There's an old expression: gaps get filled. However, this is not always true. When Edwards/Magee popularized gaps 50 years ago, they described three types of trend gaps:
BREAKAWAY: as a market breaks out into a new trend move, up or down.
CONTINUATION: as the trend goes runaway with enthusiasm or fear.
EXHAUSTION: as the trend burns out with one last surge.
Both breakaway and continuation gaps are excellent trade entry points when the trend first "pulls back" to test it. Those gaps hold support/resistance on the first test the vast majority of the time, providing a low risk-high reward entry.
The exhaustion gap fills easily and warns that the trend preceding it is over. Very often, the first test of a continuation gap occurs AFTER the closure of the exhaustion gap. It's still an excellent trade entry point but the trader needs to remain aware that the subsequent rally is likely to fail before testing that closed exhaustion gap from the other side.
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The most effective trading strategy doesn't chase a short sale immediately following a Hole. Instead, wait for the first downdraft to complete and reverse. A quick swing long can be initiated here but expect the bounce to fail. The best short opportunity comes during the completion of this next rally. Use a Fibonacci grid to lay out the move from the short term high to the post-Hole climax low. Calculate an appropriate entry point from analysis of this grid. This rally should never complete more than 62% (allowing for "noise") of the prior downdraft before failing at least once. And the Hole should not fill without an opposite gap of similar magnitude.
Each trader's time frame will bring its own exit rules. However, entry zones should be similar regardless of intended holding period. The lowest risk entry takes place during the rally back into the Hole. The simplest exit follows the subsequent downdraft. Defensive measures must be exercised with this formation as the stock still carries high relative strength and finds many willing buyers. Use cross-verification techniques to locate multiple confirmations for your timing and risk:reward conclusions. |
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| Fibonacci Measurement |
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| When MOT gapped down in a 1997 Hole, the initial decline ended at a 38% Fibonacci retracement of the 4 month trend. This popular percentage provides a powerful floor for first declines. A subsequent rally retraced almost 62% and died. Look at the typical 1-2-3 nature of the bear rally. Notice one Adam and Eve double top embedded within a smaller, second one. A sharp, quick first peak followed by a more gradual lower second peak characterizes these dependable reversal patterns. If you missed your entry at the first retracement, secondary entry points appeared as Eve rolled over and the short term lows were broken. |
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| Trading Tips |
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- The Hole itself provides an excellent cross-verification point. Regardless of retracement percentage, price should never take out a Hole on the first try, unless regapped.
- Markets that hold above their intermediate (50 day for position traders and 13 period 5-min bars for day traders) moving averages following a Hole are stronger than those that violate them. Use more defensive exit strategies until violation of this average occurs.
- Use Gap Echos as entry and exit points. Price remembers prior gap activity and will try to reverse, at least once, as these areas are approached. See MOT's red line continuation gaps in the illustration above for examples.
- Longer trends (and their pull back points) take precedence over shorter ones. Expect bounces to occur at 38%, 50% and 62% retracement points IN ALL TRENDS. Always know where these key levels are located.
- Skilled traders use all information at their disposal to develop a hierarchy of the importance of each bounce level. Trade profitability increases when positions are held through minor bounces following entrance but exited near major ones.
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