Filling in the stock price gaps

Often traders hear chatter regarding a stock’s price action returning to fill in a gap that was left behind. Sometimes someone even claims that a gap must be filled in, as if it’s a mathematical certainty like the rising of a tide. But whether a gap will be filled is less a function of mathematics and more a matter of why the gap formed in the first place.

In the furore over the proposed resources profits tax, the stock of BHP Billiton (BHP) has suffered a rollercoaster ride, breaking beneath its long-term bullish trendline, bouncing from support at 36.00, and possibly establishing an upper resistance zone between 44.00 and 45.00. More to the purpose, the stock left gaps behind in every imaginable location.

Below is a three-month daily chart of BHP, enlarged to show detail:

The gaps in late February are what are called common gaps. They have no rhyme or reason, form on normal or light volume, and are merely  blank spots on the chart. However, common gaps are often rapidly filled in, and here the price action returns within days to do so.

Further on, into March, the common gaps are interspersed with continuation gaps. These continue an already established trend, in the case of BHP a strong uptrend, and they are caused by improving (or deteriorating) fundamentals within the company driving the increase (or decrease) in the stock’s price.

Because continuation gaps are due to changed fundamentals, the price isn’t likely to return to that level soon and these gaps may wait a long time for filling. BHP, of course, rose with the expectations for the global economic recovery, and only a drastic change in those expectations could return the price to that former level.

But in early April, as global economic data become mixed, those expectations did change. At that time, the price gapped up several times, but the previously strong trend could find no traction for further gains. These are exhaustion gaps, and they form generally on low volume as a trend reaches its conclusion. They’re usually filled in very quickly, as the price action turns south.

Finally, BHP in mid to late April formed several rather small breakaway gaps on rising volume as a new downtrend got underway. Breakaway gaps, like continuation gaps, form when company fundamentals are altered and may also require a long time for the price action to return and fill them in.

However, the stock BHP seems to be establishing a trading range between support at 36.00 and a resistance zone of 44–45.00, as shown on the analysed chart, below:

Since its previous analysis, BHP has risen off support and is now in the process of filling in its lowest continuation gaps from the downtrend. Watch for a 50% retraction once these are filled, before the price continues its rise off support.

technical analysis by Craig Liles