Chapter 5. Gaps and Previous Price Movement

For a gap to occur, obviously there must be price movement from one day to the next. A gap up occurs when today’s low is higher than yesterday’s high. So on a gap up there had been an upward jump in price at the open. But what happened during the day of the gap? Did the stock close higher or lower than the open? If the closing price is higher than the opening price, you would chart it on a candlestick chart with a white candle body. If the close is lower than the open, the candle body is shaded black. This chapter examines the significance of the candle color on the day of the gap, which is referred to as Day 0, and the candle color the day before the gap, which is referred to as Day –1.

Chapter 2, “Windows on Candlestick Charts,” focused on traditional candlestick patterns that contained gaps, or windows. These short-term patterns often considered the color of the candle on the day of the gap and the colors and positions of the candles 1 or 2 days after the gap. The analysis in this chapter is different in that the price movement leading up to the gap and on the day of the gap, rather than after the gap occurs, is examined.

Gap Day Candle Color

There are six basic gap day cases to consider—three down gap possibilities and three up gap possibilities:

1. If a stock gaps down, and the price continues to fall throughout the day, the candle for the gap day, Day 0, is black. In this case, the price seems to be tumbling down.

2. A stock gaps down and the price moves up during the day, but not enough to fill the initial void on the chart. In this case, the candle on Day 0 is white—perhaps indicating that the downward fall seen at the open has reversed.

3. A stock gaps down with the opening and closing price being identical, resulting in a doji on Day 0.

4. A stock gaps up, but the price moves below the open throughout the day, closing at a price higher than the previous day’s high but lower than that day’s open. This price action results in an up gap with a black candle on the day of the gap.

5. A stock gaps up with a white candle. When this occurs, the price jumps up at the open and continues to move higher during the day.

6. The stock gaps up with the opening and closing price being identical, resulting in a doji on Day 0.

Table 5.1 summarizes results for each of these six combinations. Eighty-one-and-one-half percent of gap downs are associated with a black candle on the day of the gap. Although these down gaps are more common, they tend to be small in size, 1.24%, relative to the white candle down gaps that average 1.84%. The day of a down gap is a doji only 1.3% of the time; although these are rare, they are the only gaps that have a positive 1-day return. The nominal and market-adjusted returns for buying a stock at the open the day after a downward gapping doji occurs are all positive. Another interesting result about the down gaps is that the 1-day and 3-day nominal returns for the white down gaps are negative, but the 1-day and 3-day market-adjusted returns are positive. This indicates that even though the price of these stocks tended to fall on Day 1, the market, on average, was falling further. All three down gap possibilities had positive nominal and market-adjusted returns by Day 5.

Table 5.1. Gap Returns Based on Color of Candle on the Day of the Gap

Unlike the gap downs, which are primarily black candle gaps, gap ups tend to occur on white candles. Eighty-three percent of the gap up candles were white. However, at an average size of 1.03%, these gap ups tended to be smaller than the black candle gap ups that averaged 1.51%. It is rare for the candle on the day of a gap up to be a doji; less than 1.4% of the gap ups occur as a doji. The black candle and the white candle gap ups were alike in that they both had negative returns through the 10-day holding period and positive returns for the 30-day holding period. The white candle gap ups, however, did not reverse direction as much on Day 1 and had larger 30-day returns.

Previous Day Candle Color

If you also consider the candle color on Day –1, there are 18 possible cases. Each of the 6 cases just discussed can be preceded by either a white, black, or doji candle day. Table 5.2 reports the results for the 9 possible cases that can occur when the gap is down, and Table 5.3 reports the results for the 9 possible cases than can occur when the gap is up. A designation such as BUW is the notation used for Black-Up-White and means that Day –1 was a black candle, and Day 0 was a gap up white candle day. The other 17 cases are designated in a similar manner.

Table 5.2. Gap Returns Based on Color of Candle on Day –1 and Day 0 for Down Gaps

When looking at the 18 possible 2-day patterns, which occurs most often? Thirty-seven percent of all gaps follow the White-Up-White pattern. Thus, over one-third of all gaps seen in the market occur on strong upward price movement. The price moves upward on Day –1, jumps up at the open on Day 0, and then continues upward to close higher for Day 0. These gaps average, however, a smaller size than for any of the other 17 combinations except for the extremely rare Doji-Down-Doji pattern.

The second most commonly occurring 2-day pattern is the Black-Down-Black pattern. Twenty-nine percent of the gaps follow this pattern. Like the White-Up-White pattern, the Black-Down-Black pattern also indicates strong price movement, just in a downward direction. The price moves lower during Day–1, the price jumps lower at the open on Day 0, and then the price continues lower during trading on Day 0.

Together, the White-Up-White and Black-Down-White patterns account for two-thirds of the gaps seen in the stock market. What are the rarest patterns to see? Gaps that have a doji on Day –1 or Day 0 rarely occur. Only 3% of the gaps have a doji on either of these days. Of those patterns that do not include a doji, the Black-Up-Black and the White-Down-White patterns are the least common. Less than 2% of gaps follow the Black-Up-Black pattern, but these rare up gaps provide the largest sized up gaps. Slightly rarer, the White-Down-White pattern has the largest gap size, 2.48, of any pattern combination.

Now look more closely at the returns for down gaps presented in Table 5.2. As you saw earlier, down gaps that occur with a black candle average a 1-day return of –0.0240. Looking more closely, however, you can see that this negative return is greatly influenced by those black candle down gaps preceded by a white candle on Day –1. Only 17% of black candle down gaps are preceded by a white candle, but the White-Down-Black pattern has a 1-day return of –0.2952, the lowest of any of the 2-day candle down gap combinations, except the White-Down-Doji pattern. The gap down black candles preceded by a black candle actually have a positive 1-day return of 0.0383. The Black-Down-Black pattern occurs when the price moves lower during the day on Day –1, jumps down at the open on Day 0, and then continues down further during the day to form the second black candle. This pattern sees immediate reversal, with positive 1-day returns. This upward price continues, resulting in the Black-Down-Black having the highest 5-day, 10-day, and 30-day returns of any of the nondoji gap patterns considered. The results for the White-Down-Black pattern are much different; positive returns do not occur until the 30-day holding period; even then, the 30-day return of 0.1869 is the smallest of any of the gap patterns, and the market-adjusted return is still negative.

Interestingly, you can see similar results for the gap down white candle patterns as you did for the gap down black candle patterns. On average, when a stock gaps down on a white candle, the 1-day and 3-day returns are negative. This remains true when the day before the gap is a white candle day, resulting in the White-Down-White pattern having negative 1-day and 3-day returns. This is not the case, however, with the much more frequently occurring Black-Down-White pattern. For the Black-Down-White pattern, the returns and market-adjusted returns for all holding periods considered are positive.

Table 5.3 presents results for up gaps. When all up gaps are lumped together, when black candle up gaps are considered as a group, and when white candle up gaps are grouped together, the 1-day, 3-day, 5-day, and 10-day returns are all negative. Adding the color of the Day –1 candle refines the results a bit. If Day –1 is a white candle day, the results do not change, but if Day –1 is a black candle day, you see a slightly different story. For the Black-Up-White, the 1-day return is 0.0810, the highest for any of the nondoji patterns considered.

Table 5.3. Gap Returns Based on Color of Candle on Day –1 and Day 0 for Up Gaps

Thus, Day –1 color does seem to matter. The general results suggest that shorting a stock the day after it gaps could be a profitable trading strategy. However, if the day before the gap were a black candle, the results in Tables 5.2 and 5.3 suggest considering a long position.

Dramatic Price Move Examples

Now consider some specific examples of dramatic price movements that follow common Black-Down-Black and White-Up-White patterns. By September 15, 2008, American International Group (AIG) was already spinning wildly out of control. In December 2000, AIG peaked at more than 2000. By the beginning of 2002, AIG had fallen below 1500. For about the next 5 years, AIG traded in a range roughly between 1000 and 1500. AIG closed February 2008 below 1000 for the first time since February 2003. By mid-May, AIG had fallen below 800. AIG’s steady decline throughout the summer of 2008 is shown in Figure 5.1.

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Figure 5.1. Daily stock chart for AIG, May 8–October 7, 2008

The stock was in free fall. On Friday, September 12, AIG fell from about 300 to close at 234.52. On Monday, September 15, it opened with a gap down of more than 30% and closed down 60.8% from the September 15 close, forming a Black-Down-Black. On September 16, AIG opened at 37, down dramatically from the previous day’s close of 95.20. But, September 16 turned out to be a dramatic reversal with the stock closing at 75—more than a 100% increase in one day!

People who say that the stock market is boring just haven’t looked closely enough. Take Jammin Java Corporation (JAMN) in May 2011, for instance. If the company’s name and ticker symbol make you think of Bob Marley and reggae music, there’s a good reason. Jammin Java was founded by Rohan Marley, son of the late Bob Marley and a star linebacker at the University of Miami in the early ’90s. On January 10, 2011 JAMN’s total volume was a whopping 500 shares and the price was 51 cents. On May 12, the stock gapped up with the price hitting a high of 6.35 per share and closing at 5.42 on volume of more than 20 million shares (see Figure 5.2). The rise was meteoric going from about 1 per share in March to the high of 6.35 in less than 2 months.

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Figure 5.2. Daily stock chart for JAMN, May 26–June 1, 2011

But, on May 13, things began to unravel with four consecutive black candle days. The stock fell from an opening price of 5.59 on the 13th to a close of 1.52 on May 18, experiencing an intraday low of 92 cents on the 18th. JAMN’s price movement provides an example of what the results in this chapter suggest is a typical price movement after a White-Up-White pattern occurs. Investors who purchased JAMN at the open the day after the gap would experience negative 1-day, 3-day, 5-day, and 10-day returns.

On June 14, 2011, JAMN fell below 2; it closed the year at 27 cents per share. What caused this wild ride? The answer isn’t clear, but in September there were news reports that the SEC was investigating a possible illegal online pump and dump scheme. The company issued a statement on September 9 saying that they had become aware of some unauthorized Internet stock promotion in May and that Rohan Marley strongly condemned such actions. The company vowed to cooperate fully with the SEC investigation.

JAMN wasn’t the only coffee company with a wild ride in 2011. Coffee Holding Company, Inc. (JVA) began the year at 3.85 and ended the year at 7.84, an increase of more than 100%. However, that was nothing compared to what happened in between those dates. On July 11, 2011, the stock hit a high for the year of 30.98, gapping up on a White-Up-White pattern (see Figure 5.3). An investor who saw this pattern might have reasoned that the stock’s tripling in price over the prior month was an unsustainable uptrend. Thinking this was an exhaustion gap, the investor might have shorted the stock at the open on July 12 at 29.54 and enjoyed the fall that same day to a close of 22.37. The next 2 days were also black candle days with the stock closing at 18.89 on July 14.

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Figure 5.3. Daily stock chart for JVA, May 14–August 1, 2011

Summary

Gaps have generally been thought of as signaling a strong directional price move. Traditionally, traders have looked for breakaway gaps as a signal that a new trend in the direction of the gap has occurred. In addition, measuring gaps signal that the trend is going to continue in the direction of the gap. Among those who practice Japanese candlestick charting, the adage is “go in the direction of the window.”

The results show that price movement does tend to continue downward when a down gap occurs, but only for about a day. You might think that spotting a black candle followed by another black candle that gaps down would be an ominous sign; this might mean that downward price movement is gaining momentum. However, the results show that when a black candle on Day –1 is followed by a gap on Day 0, price movement tends to reverse to an upward direction on Day 1, and this upward movement continues for at least 30 days. This suggests that the downward gap was an overreaction and the price fell too far.

Likewise, you might think that an up gap, especially when it occurs in a White-Up-White pattern, suggests strong upward price momentum. Again, the results bring this traditional reasoning into question. Stocks tend to reverse direction and have negative returns for a couple of weeks following an up gap.