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Investing? Understand the profit-booking theory

August 24, 2009 11:21 IST
Filled gaps can be used as crucial support and resistance levels, says Vinod Sharma.

Markets are a function of human emotions. Any significant news that relates to the sector, index or an individual stock can result in temporary mismatch in demand and supply.

Such extreme events results in price gaps. Price gaps are areas on a chart where no trading has taken place. Stocks regularly gap on earnings announcements, merger and acquisition news and on managerial shakeups.

In an uptrend, for example, the price opens above the highest price of the previous day, leaving a gap or space on the chart that is not filled during that day. In a downtrend, the day's highest price is below the previous day's low.

Upside gaps are signs of market strength, while downside gaps usually signs of weakness. Gaps are more commonly seen on a daily bar or candle chart, but can appear on long-term charts like weekly or monthly ones. A gap in a long-term chart is considered very significant.

Several myths exist concerning the interpretation of gaps. One of the maxims often heard is, 'Gaps are always filled'. This is simply not true. Some should be filled and some should not.

In a perfect world, of course, all trends would maintain a consistent, interpretable pattern, without chaotic activity. However, what happens when there is a break, or "gap," in the trend on the price chart?  Is there really a significant change brewing?  Or, is it just a slight interruption in the pattern?  To help determine what these gaps signify, a study of Gap Theory is necessary.

Gaps are technical phenomena that may or may not mean anything. Some markets are, by their nature, predisposed to gapping, for example, the Hong Kong Index. While others rarely display gaps, like the Sensex.

Gaps are frequently accompanied by an increase in volume. Thus, interest in buying or selling accumulates and pushes price significantly in one direction or the other.

Filling of the Gap can act as a support and resistance. Once a gap occurs, the price usually retraces, and this phenomenon is commonly known as "filling the gap". Every time it's not necessary for the price to fill the whole gap and reverse; sometimes the price reverses by partially filling up the gap.

Filled Gaps can be used as crucial support and resistance levels, which can be utilised to identify the major reversal and profit booking points. For example, an upside gap might act as a crucial support when the price starts correcting from the top and the downside gap can act as a major resistance when the price starts rising from the bottom.

Let us discuss a live example which explains how the gap in an uptrend can act as a crucial support. The 15th Lok Sabha election results were announced on Saturday, May 16, which was a major positive surprise for the markets. When the markets opened for trade on May 18, the Sensex opened with a huge gap of 1,300-odd points.

It opened at 13,479, against the previous close of 12,173. This gap was partially filled on July 13 and the index bounced back significantly thereafter. The index made a new high of 16,002 on August 4, recovering 21 per cent from the support.

Once you understand the common gaps and what they mean, you can profit by correctly assessing them.

The writer is director and head of research, Anagram Capital.

Vinod Sharma
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