Discussion 11 (Part 1) : Playing the Gap (Basic Hand)

Coming from an accountancy background, it is only natural that most of my friends come from that field as well. However, being accountants and auditors don't necessarily mean that we possess above average financial knowledge. I had this conversation with my friend, who has read Discussion 9, and asked me this,

"How could Gaps happen? Isn't the opening balance of the next day equal to the closing of previous day?"

My response to her was,
"We are not preparing accounts!"

A few days later, another friend of mine asked me the same question after reading Discussion 9, and again, I told her the same thing. After hearing that, she exclaimed that investing is risky. Stock trading is risky. You could lose hundreds or thousands in just a morning due to a Gap. She then went on to close her mind on the subject matter.

I did not respond further. Sometimes, I feel that if I were to gather a group of 10 accountants or auditors, I will get 9 paradoxically formed animals. Like an eagle, they proudly perform risk assessments and majestically criticize others' risk management policies, but they immediately turned into a scaredy-cat when they assess and manage their own financial risks!

In fact, I very much agree with my friend on the risks that are present due to a Gap movement. However, rather than turning away from the stock market, I seek a way to bend that risk into a weapon of financial wealth! Let me now share with you some fundamental knowledge on how to play the Gap in our favour.


CONVERGING EASTERN AND WESTERN TERMINOLOGIES
In Japanese terminology, a Western "Gap" is called a "Window". In my Discussions, I will use Gaps and Windows interchangeably, as they essentially mean the same thing.

A Western "Gap Up", is a Japanese "Rising Window", while a Western "Gap Down", is a Japanese "Falling Window".


IDENTIFYING WINDOWS


Illustration (i) : Window

Windows are identified as an empty vacuum between two candlesticks. In other words, it means, there must be a 'gap' between the first candle's high/low and second candle's low/high.

Know that the key here is the candles' high and low, not the real body. If the shadows of the candles exist in the empty space, then there is no empty vacuum, and therefore, no Window. See illustration (i).


WINDOW AS A CONTINUATION PATTERN



Illustration (ii) : Rising & Falling Window

Most of the time, we see a Window as a continuation of the prevalent trend. As the Japanese saying goes, "Go in the direction of the Window". This is the very basic that you must have in mind when playing a gap.

If a Rising Window is formed in an uptrend, then traders/investors may seek to buy when the price takes a retracement. If a Falling Window is formed in a downtrend, then you may seek to sell when a rebound occurs. Refer illustration (ii).


WINDOW AS SUPPORT & RESISTANCE



Illustration (iii) : Support & Resistance Area

Japanese says, "Corrections stop at the Window". Windows act as a support or resistance of price movements.

In a Rising Window, the area between the low of the second candle and the high of the first candle would act as a support area, with the high of the first candle being he last line of support.

In a Falling Window, the area between the high of the second candle and the low of the first candle would act as a resistance area, with the low of the second candle being the last line of resistance.

The volume on the gapping day would serve to tell the strength of the resistance or support. Higher volume means stronger resistance or support, and vice versa.



Illustration (iv) : Gap Breakout Play

Traders may time for a breakout play this way. A breakout is usually confirmed by a close above the resistance or below a support. Merely having a shadow peeking above a resistance or below a support doesn't confirm that the resistance or support is broken. The general rule is to enter into the play after a breakout is confirmed, as seen in illustration (iv).

However, a handful of competent traders trade on breakout strategies during the formation of the candle itself. If there is a high volume during the intra-day, and the trader is confident that the price would close above the resistance or below the support, he may make an early entry to maximize profits.


PUTTING IT ALL TOGETHER
Let's study KNM. Refer Illustration (v).



Illustration (v) : Gap Analysis - KNM

Three Rising Windows (RW) are seen in KNM daily chart. Notice that in all three RW days, the volume is considerably enormous compared to others. This shows the strength of the support areas, as well as the strength of the trend.

An ideal entry would be after the retracement following the first RW on 06/12, when the price closes on the support of MA50d. Coincidently, that was the time when MA50d crosses over MA100d, giving a bullish signal as well. The stock price then rallied to make another two RW.

After the third RW, the stock retraced to test the support area of RM2.80 - RM 2.81, before making another higher low. A stop loss should be adjusted to just below the higher low, at approximately RM3.00. The reason for this is that in an uptrend, the stock price should make a higher high and a higher low. The trend was then broken on 21/01 when it is unable to make another higher low.

After tested the third RW's support area for a number of times, the support was finally broken on 23/02. The Bullish Counterattack Pattern wasn't good enough to sustain the support area, due to poor volume. On 24/02, the stock price plummetted down to the next support area formed on the previous RW, at RM2.34 - RM2.37.

On 03/03, a Bullish Hammer was formed at support area. Together with the black candle on 02/03, these two candles complete the Bullish Harami Pattern.

A RW was seen the next day on 04/03, with its lower shadow resting on its support of MA100d, accompanied by healthy volume. All these lead to a bullish signal, with the immediate resistance area of RM2.80 - RM2.81 (support turned resistance). This bullish attempt is confirmed to be a failure when the price closes below RM2.29 (the low of previous Bullish Hammer).


This concludes the first instalment of Playing the Gap. It is reminded that trading at the gap is arguably a risky strategy to trade. However, competent traders usually make use of more advanced strategies to ensure that their 'bet' at the gap has a higher winning probability. This, I will address in Discussion 11 (Part 2) : Playing the Gap (Professional Hand).

Happy trading on the fruitful week ahead!


[Disclaimer: The only reason I made use of KNM in this Discussion as my example is that it illustrates Gap Analysis closer to current date. It certainly does not constitute to a suggestion or recommendation to buy or sell KNM shares. >.<]