Top Advisors Corner

Martha Stokes: Island Gaps and Bottoming Formations


Understanding Resistance and Support factors of Gaps

All traders who use Technical Analysis learn the following 5 Basic Gaps:

1.    Island Gap
2.    Breakaway Gap
3.    Measuring or Running Gap
4.    Exhaustion Gap
5.    Common Gap

Traders are taught that each type of gap represents a different price reaction after the gap, due to where that particular gap is supposed to form in a trend. However sometimes gaps do not form where they normally occur in a strongly Downtrending or Uptrending stock. In fact often where gaps form in Downtrends, is totally different than where they form in Uptrends.

The Market Participant Group which creates the gap impacts the resistance or support a gap will provide in various levels of a trend, starting with the Bottoming Formation pattern which is the study lesson for this article.

If you need a review of how I interpret gaps and the relevance to the near term price action, please visit our website or email and request the lesson topic. Most of you already know gaps so I am not reviewing today.

Island Gaps and Bottoming Formations often start with a huge gap down created by High Frequency Traders HFTs providing liquidity in a Downtrend. They are also attempting to drive price down for profits from Buy to Covers as the stock sells down due to Volume Weighted Average Price VWAP from smaller funds automated orders, which trigger on any surge of Volume as well as Retail Traders trading.

In the chart example of Universal Display Corp. (NASDAQ: OLED) below, there is an HFT gap down which is followed by smaller funds VWAP orders which trigger on huge Volume surges. 

However at the same time the candlesticks and indicators that track the Buy Side Institutions bargain hunters buying giant lots, begin to show the signs of Quiet Accumulation occurring.

Most Bottom Formations are volatile due to the conflict between these institutions using hidden Dark Pools to buy into a stock while HFTs, smaller funds, and the retail crowd are selling or selling short. The giant lot Buy Side Institutions always win this battle, as they have the weight of Quantity on their side. 

Unfortunately, Technical and Retail Traders who do not see the candlestick and indicator patterns of these giants often have Sell Short losses. What is important to watch for are the tell-tale signs of the bargain hunters. The largest institutions which comprise the top 25 Buy Side Institutions tend to buy in a range I call a “Dark Pool Buy Zone.” Their orders are automated and trigger as soon as a stock drops into their zone range. Their incremental buying called Time Weighted Average Price TWAP orders, halt when price moves beyond that range either up or down.

The Dark Pool Buy Zone™ is clearly defined in this chart example and may seem wide to a Technical or Retail Trader, but keep in mind these giant Buy Side Institutions are strictly long term investing at this point for mutual and pension funds. Meanwhile the stock reaches the high of the Buy Zone and the buying of stocks triggers a mistake by an HFT that creates a selling short gap down, which then drives price right back into the bargain hunting Dark Pool Buy Zone. HFTs quickly react and gap the stock up, forming a classic Island Gap reversal pattern which concludes the Bottoming Formation. Then the stock runs with momentum, allowing for good entries for Technical and Retail Traders as well as Options Traders.

Trade Wisely,

Martha Stokes CMT

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