When planning new gapper trades, the Hole-in-the-Wall
should be your first stop. Edwards and Magee briefly mention them in their classic
Technical Analysis of Stock Trends. In the section on trend theory, they discuss
an Island Reversal's important second gap. E/M refer to this move as a
counter trend breakaway gap although it doesn't follow rules they 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.
The most effective trade strategy will avoid short sales
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.