EWI eBook

How to Trade the Highest-Probability

Opportunities: Price Gaps

By Jeffrey Kennedy, Elliott Wave International

Chapter 1 — Price Gaps Defined

Chapter 2 — The Importance of Price Gaps

Chapter 3 — How Price Gaps Relate to Technical Analysis and the

Wave Principle

Chapter 4 — The Gap Breakout Level

Chapter 5 — Price Gap Trade Setups

Chapter 6 — Questions and Answers

Introduction
In this course, I will discuss price gaps and their importance with respect to
the Wave Principle. The main point I would like to make is that price gaps
offer much information that is useful to the active trader — more than is
currently thought. While many books on technical analysis supply only
limited information on price gaps, I will show you that price gaps deserve
much more attention, from both an analytical and a trading perspective.

Jeffrey Kennedy Editor of

Futures Junctures
, Elliott Wave International’s
premier commodities forecasting service

Editor’s note:
This webinar was originally presented live online on June 24,
2008.
Chapter 1
Price Gaps Defined
A price gap occurs when securities or commodity prices move significantly
from one trading session to another so that their trading ranges do not
overlap. I call this kind of price gap a
hard gap
. But I also recognize a
soft
gap
, in which the closing price of the previous session does not fall within
the trading range of the current bar.
Figure 1-1
More specifically, a
hard gap
, illustrated on the left in Figure 1-1, occurs
when the range of the current bar does not include the range of the previous
bar, leaving a space between the two bars. The blank space between the two
price bars makes it easy to see the gap on a price chart.

A
soft gap
, illustrated on the right, doesn’t appear to have a space between
the two bars when taken at a glance, but upon closer examination, you
realize that the close of the previous bar is not included in the range of the
current bar. It’s still a gap, but it’s not as easy to see as a hard gap. Let’s
take a look at some examples showing the difference between the two.
Figure 1-2
Note the easy-to-spot hard gap that appears as a space on this weekly price
chart of Coffee.

Figure 1-3
These two hard gaps on this 60-minute price chart of Soybeans illustrate the
traditional definition of a price gap. Price gaps occur in just about every
financial market.

Figure 1-4

Here is a price gap on the 60-minute chart of an actual individual stock —

Sepracor (formerly Nasdaq: SEPR).

Figure 1-5

Now take a look at a price gap that occurred on its monthly price chart.
Figures 1-6 and 1-7
These two charts portray examples of hard price gaps in daily Intel
(Nasdaq: INTC) and on the five-minute E-mini S&P 500, respectively.
Taken together, these six charts show that price gaps can occur on any time
frame and in any market.

Figures 1-6 and 1-7

These two charts portray examples of hard price gaps in daily Intel
(Nasdaq: INTC) and on the five-minute E-mini S&P 500, respectively.
Taken together, these six charts show that price gaps can occur on any time
frame and in any market.
Figure 1-8
While large spaces clearly identify hard gaps, it’s more difficult to decipher
soft gaps.
Figure 1-8 uses a program that I wrote to pinpoint where hard and soft price
gaps occur. The green arrows indicate bullish hard gaps up, the red arrows
indicate bearish hard gaps down, and the green and red dots denote soft
gaps.

Figure 1-9
Here’s a close-up to allow you to study a few enlarged soft gaps. So why do
I bother to distinguish between hard and soft gaps? Let me show you in
detail how useful it can be to do so.

Figure 1-10
This monthly price chart of the Dow reveals that while hard price gaps are
absent, the soft gaps identified by the program portray significant levels of
support, resistance, and trading opportunities.

Figure 1-11
This Gold chart reinforces the importance of differentiating between hard
gaps and soft gaps, as soft gaps dot the entire monthly price chart, yet hard
gaps are absent.

Figure 1-12
Similarly, this weekly stock chart contained only one hard price gap
(circled) in price action spanning a period of more than one-and-a-half
years. However, we can see 15 soft gaps that point out other significant
price levels. Thus, it is important to label the two different kinds of price
gaps, because if hard gaps don’t show up, soft gaps can provide useful
information to those who seek out high-probability trading opportunities.
Chapter 2
The Importance of Price Gaps
Why are price gaps important for traders to understand? I frequently discuss
this simple but critical answer in
Daily Futures Juncture
s and
Monthly
Futures Junctures
, two of the publications I edit. Price gaps are important,
because they act as support and resistance for the market. They also often
act like magnets, first attracting and then repelling prices.
Figure 2-1
This combined sessions chart of July Soybeans (with soft-gap identification
removed) shows two price gaps on the left-hand side of the chart that act
like magnets. First, they attract prices down to the blue horizontal lines
(support) and then repel them in a price reversal.
Figure 2-2
Moving forward in time on this same Soybeans chart, we come to a bearish
gap to the downside followed by two bullish gaps to the upside.
Again, the price gaps clearly identify significant levels of support and
resistance (marked by the blue horizontal lines).
For example, the bearish price gap in red identifies key support for theApril
sell-off, and the top green price gap provides a nice shelf of support for the
pullback in May and subsequent rally to the upside.
Ultimately, price gaps are important because they act as
psychological
markers
. What do I mean by that? Let me explain with a short anecdote.
Three or four years ago, as I drove through an intersection without paying
much attention to my surroundings, I had a car accident. Now, whenever I
drive through that intersection, I always remember that wreck; the
intersection is a psychological marker for me.
Similarly, when prices gap, they leave behind psychological markers that
the market remembers. For example, at the arrows in Figure 2-2, a number
of people were happy because they were long Soybeans, and the market
went their way. They will thus remember that moment fondly. Others were
short, and the market did not go their way. They will remember that day as
one of their worst trading days. Since price gaps become imprinted in your
mind, they are critically important to understand in regard to your own
analysis.
Figure 2-3
This Cocoa chart shows another example of price gaps acting like magnets.
The pair of price gaps on the left of the chart (indicated by the green
arrows) provided excellent resistance for the move up that began in April,
while the bearish gap (red arrow) provided a solid shelf of support as the
market came back down and eventually was repelled to bounce back up.

Figure 2-4
Now that you have seen evidence of the importance of hard price gaps, let’s
see whether soft gaps can provide useful information, too. I ran my program
that identifies soft gaps on this weekly chart of Wheat.
Note that the soft gap marked by the blue line extending from it provided
support for the two underlined pullbacks. Although there is more noise with
soft gaps, simply because there are more of them than there are hard gaps,
they can still provide solid information about where prices are headed.

Figure 2-5
Price gaps apply to all markets and time frames. So, for example, here is a
60-minute combined sessions price chart of Sugar. As you can see from the
extended blue lines, the market traveled up and “closed the price gap” (as
traditional technical analysts would say), which then acted as resistance,
prompting a pullback. In addition, the circled bearish price gaps with the
extended red lines provided support as the market pulled back. Look what
happened to the market overall: It went up and was attracted to the recent
price gaps, and then it pulled back into support provided by the earlier price
gaps.
This chart illustrates an important lesson: If you see a price gap, draw a
horizontal line on your price chart and leave it there, because it will often
become significant and play a part in your analysis at some point.
Figure 2-6
Notice the interesting price gap formations in the 30-minute E-mini chart in
Figure 2-6. The red price gap in the middle of the chart provided resistance
to the push up, while the green price gap lent support for the turn back up.

Figure 2-7
Here’s a stock chart of Verizon (NYSE: VZ) that summarizes what we’ve
discussed in this section. The chart looks like a bloody mess, doesn’t it?
With so many hard gap and soft gap labels, you may wonder which ones are
sig
nificant.
Figure 2-8
To clarify this chaotic picture, let’s begin at the high and work through each
of the individual moves within the sell-off. Verizon tops in May, travels
down to supportive price gap number 1, and then turns back up to encounter
resistance at soft gap number 2. Once prices hit resistance, they sell off and
close hard gap number 3. Next, the market turns back up and finds
resistance at soft gap number 4, falls to the downside to soft gap number 5,
and turns back up to resistance at soft gap number 6. Prices then sell off and
encounter a small one-day bounce to close soft gap number 7, and finally
push lower in April to close gap number 8.
All these moves clearly depict a congestion phase of the market, because
there’s no real trend, as prices simply travel sideways. Despite the massive
number of price gaps, there is a method to the madness. To actually employ
price-gap analysis in your traditional studies of price charts, you must use
an appropriate indicator. In this choppy market, the most appropriate
indicator would be oscillators – such as stochastics or RSI. However, if it
were a trending market, you would use a different aspect of price-gap
analysis and a different indicator, such as a MACD or moving averages.
Using an oscillator (perhaps a slow stochastic) with this gap analysis could
have allowed a short-term trader or a day trader to catch many of the swings
in this market.

Which price gaps
are important when there are so many of them? I believe that all price gaps
are significant, yet hard gaps hold a bit more weight than soft gaps, and
price gaps that occur in electronic or combined sessions trading are more
important than those that occur in pit trading. Let’s see why by comparing
two Soybeans charts, one based on daily pit trading, the other based on
combined sessions.
Figure 2-9
As you know, we’re moving toward a global economy where you can trade
any financial market anywhere in the world 24 hours a day. Here is a chart
of Soybeans pit trading. Many of the price gaps, which result from
overnight or electronic trading, are of little importance, because the chart
displays the transition from one day to the next day in the pit as the world
turns
Figure 2-10
In contrast, the Soybeans combined sessions chart in Figure 2-10 smoothes
out the abrupt ups and downs of the pit trading chart by presenting the
entirety of the trading, which eliminates many of the noisy gaps and
identifies critical levels. Notice that by using the combined sessions version
of Soybeans, the chart displays only three price gaps as opposed to 16 on
the pit trading price chart.
Chapter 3
How Price Gaps Relate to Technical Analysis and the Wave
Principle
Now, let’s briefly look at how price gaps relate to traditional technical
analysis (you can find more detail in any book on technical analysis) and
then how they relate to the Wave Principle.
Figure 3-1
This Intel price chart (Nasdaq: INTC) demonstrates the four types of price
gaps in traditional technical analysis: the common gap, breakaway gap,
acceleration gap and exhaustion gap. The first type — the common gap
(circled) — occurs at tops, bottoms and congestion phases. Although
traditional technicians believe that there’s little forecasting value in this
type of price gap, I think that all price gaps are important.

Figure 3-2
According to traditional technical analysis, the gap near the blue line at the
top of this enlarged version of the Intel chart is considered to be a
breakaway gap, because it occurs on the heels of a congestion period. The
second blue line is an example of an acceleration gap, which is sometimes
referred to as a continuation or measuring gap. It holds a special place in
forecasting, because it tends to mark the midpoint of a move (hence the
name, measuring gap).

Figure 3-3
Lastly,the gap marked by the lower blue line is an exhaustion gap, which
typically occurs in the very late stages of an impulsive move, either to the
upside or downside.

Figure 3-4
An island reversal is another common, traditional chart pattern used by old-
school technicians.As you can see in this Verizon price chart (NYSE: VZ),
prices gapped to the downside and then gapped to the upside in a period of
days. This hard gap down followed by a hard gap up is an island reversal. In
this case, it signaled a bottom, and prices did indeed advance thereafter.

Figure 3-5
Here is a near-textbook example of an island reversal on a 60-minute chart
of Live Cattle. Prices gapped down and then gapped up, leading to a rally.

Figure 3-6
Now, let’s move on to how price gaps relate to the Wave Principle. Those of
you familiar with the Wave Principle know that prices travel the farthest in
the shortest amount of time in a motive or impulse wave (waves 1, 3, and
5). One way they accomplish this speedy travel is by gapping to either the
upside or the downside. One trick to zero in on a correct wave count is to
keep in mind that price gaps tend to occur in the wave-three position as
shown by the figure on the left side of this illustration. In the right-side
figure, I’ve marked an entire five-wave move, including the subdivisions
and the traditional defini
tion of price gaps. Wave 3 of 1 holds a
breakaway gap, wave 3 of 3 includes an acceleration gap, and wave 3 of
5 contains an exhaustion gap.

Exhaustion gaps tend to be closed by subsequent price movements. After

wave 5 ends, prices would come down in wave A, move up in wave B, and
come back down in wave C to the previous fourth wave, thereby closing the
gap. This, then, illustrates how to use price gaps to identify third waves or
impulsive structures when using the Wave Principle.

Chapter 4
The Gap Breakout Level
Even though we now know where the different kinds of price gaps can
appear in an Elliott wave pattern, there’s still a basic question to answer:
Once prices gap, will they continue in the same direction or change
direction? A technique that I developed can help to answer that question.
It’s called the
gap breakout level
.
Figure 4-1
The best way to understand how my gap breakout level technique works is
to use it on the weekly Coffee chart in Figure 4-1. To determine the
breakout level, simply measure the length of the bar preceding the price gap
and add that amount to the top of the bar following the gap. This new level
(marked by the dark blue horizontal line) is what I consider to be the
breakout level, and we mark it on the chart as the 1.000 level.
If prices can decisively penetrate this gap breakout level in subsequent bars,
the move will continue in the same direction. However, if prices stall, as
they did here, then a retracement will occur. Either the market will travel
sideways for a period of time or the market will decline in an attempt to
close the gap.

Figure 4-2
Here is an image to clarify this information. To determine the gap breakout
level, measure the distance from the low to the high of the bar preceding the
gap and add it to the high of the move following the gap. If prices travel
through the gap breakout level, but can’t decisively close above it, odds are
that the market will decline.
Figure 4-3
On the other hand, if prices decisively penetrate this level (as shown in
Figure 4-3), then this gap is probably a breakaway or acceleration gap, and
the market will continue higher. This simple technique allows you to
differentiate among common gaps, breakaway gaps, acceleration gaps and
exhaustion gaps.

Figure 4-4
Now, let’s put this technique into practice on the daily chart of Johnson &
Johnson (NYSE: JNJ) in Figure 4-4. As you can see, prices penetrated the
breakout level (top blue line) but could not strike through it in a sound and
sustained manner, and the market traveled back down and closed the gap.
This simple approach can be a powerful technique. It works in any market
on any time frame. To prove that, let’s look at indexes, individual stocks
and commodities, on three time frames.
Figure 4-5
In the previous figure, the stock did not definitively penetrate the breakout
level. When prices do successfully break above the line, as in Figure 4-5,
how can you estimate where they will move to? Use my Fibonacci price
gap measuring formula to find some possible price objectives.

Figure 4-6
Here’s how to do it: Just measure the distance between the low of the bar
preceding the gap and the high of the bar following the gap and multiply it
by the standard Fibonacci multiples used to identify impulse waves with the
Wave Principle (1.618, 2.618, and 4.236). If prices decisively penetrate the
gap breakout level, then we have three possibilities for where prices will
end up. Incidentally, you can use a momentum study, moving averages, or
MACD in this type of market to assist with this analysis.

Figure 4-7
Here’s the strategy at work, using a monthly price chart for Cotton. Note the
breakout level marked by the top short dark blue line. Next, measure the
distance from the high of the bar prior to the gap to the low of the following
bar to the downside. Interestingly, prices go down to the 2.618 multiple of
that measurement at 3403, toy with the area, and then reverse. This kind of
discovery is what makes me passionate about technical analysis even after
15 years of looking at price charts. By using just two price bars with a
simple application of basic Fibonacci math, we were able to identify where
this sell-off might cease on a monthly scale and establish a strong support
level in the market.
Figure 4-8
Here is another example of Fibonacci gap measuring analysis on a Lean
Hogs chart. I like to utilize the equalized active charts for the meat
complex. Measure the high and low of the middle price gap and project
downward.A4.236 multiple comes in at 7040.

Figure 4-9
Measuring the lower price gap gives us a 1.618 multiple coming in at 6713.
The Fibonacci gap measurement of both of the gaps targeted a narrow range
(between the dark blue lines) for a reversal in Lean Hogs.
Figure 4-10
Here’s a weekly chart of Intel (Nasdaq: INTC). By taking the range of the
bar prior to the gap denoted by the second green arrow and adding it to the
top of the bar following the gap, we arrive at a gap breakout level of 2129.

Figure 4-11
Since Intel’s price decisively penetrated the breakout level, we next project
forward by measuring the distance between the low of the bar preceding the
gap and the high of the bar after the gap. It broke through the 1.618 multiple
to attain 2.618, which sparked a short reversal before traveling even higher
to the 4.236 level.Again, a simple Fibonacci multiple of two price bars
identified 2798 as the objective for the move spawned by this price gap.
The exciting part is that 2798 is the 4.236 multiple of this range — only one
penny off the high of 2799. Keep in mind that it is rare to have such a
perfect fit. Usually, prices cut short or exceed by a bit the projected
Fibonacci objective.
Figure 4-12
Price gaps do not have to accomplish major jumps in price to be significant.
Take a look at the small gap in Gold on the weekly price chart in Figure 4-
12. This chart portrays a common saying: A picture is worth a thousand
words. If you look closely enough, this chart will tell you a grand
story.After prices decisively penetrated the breakout level, the market came
within pennies of achieving the 2.618 multiple of the simple price gap,
backed off and then took off through its 6.854 multiple (the next highest
Fibonacci multiple above 4.236). When the market reached each of these
levels, they sparked reversals.

Figure 4-13
Time and time again, you will see that these Fibonacci levels spark
reversals in the market. Figure 4-13 displays a clear hard gap on Silver’s
weekly price chart. The decisive penetration of the break
out level at 15.73
(short dark blue line) tells you that the price gap is neither an exhaustion
gap nor a common gap and that the move will continue.

Figure 4-14
Where’s the Silver market going to go? After completing a Fibonacci gap
analysis of two price bars, you know that it’s going to go to one of three
levels.As you can see in Figure 4-14, the market easily surpasses the 1.618
multiple, decisively penetrates the 2.618 multiple, travelsright to the 4.236
multiple at 20.87, and subsequently tanks.

Figure 4-15
Now, let’s similarly analyze Wheat’s price chart. Here’s the chart with four
hard gaps marked by the arrows.

Figure 4-16
Figure 4-16 takes a closer look at the first gap on the chart. By determining
the breakout level, you know what this market must move below decisively
to tell you whether prices will continue to move in the direction of the
trend. If so, the price gap is a breakaway gap or an acceleration gap. There
is no decisive break of the blue line that indicates the breakout level. Prices
pushed through it but couldn’t even get a weekly close below this level.
Therefore, you know that the gap is most likely an exhaustion or common
gap and that the move will not continue.

Figure 4-17
Sometimes the process can be slightly trickier. On this same Wheat chart, I
used the gap breakout level technique to project the breakout level (line
with pencil icon) for the second price gap in green. Yet, can you say with
confidence that the market decisively penetrates the level? On a weekly
closing basis, it clearly closed above the level, but there was absolutely no
conviction or follow-through in the following week, as it was an inside bar.
My advice in a situation like this is to wait until the following week, when
there might be clear evidence of penetration, and then apply Fibonacci price
gap measurements to identify where this move might go.
Figure 4-18
The market closes above the 2.618 multiple, yields an inside week, and then
turns down.
Figure 4-19
Let’s continue on with Wheat’s next hard gap to the downside. As a
reminder, to determine the gap breakout level, take the range of the bar
preceding the gap and add it to the low of the bar following the price gap
(indicated by the 1.000 level on the chart).
Figure 4-20
Notice that the breakout level presents a few issues again. The range of the
week following penetration of the level is much smaller than the range of
the previous week, and the open and close are very near to one another,
meaning that the bulls and bears do not know what to do. Furthermore, the
second blue line drawn on top of the first actually closes a soft gap, which
provided support for a market reversal.

Figure 4-21
Here is Wheat’s final gap to the high.
Just for argument’s sake, let’s say that we think the market is working a
series of wave 1s and 2s to the upside and that Wheat will climb to $30.00 a
bushel. You can use the information you’ve learned to determine the
breakout level and targets following the price gap. For the market to
continue higher, it must break through the 13.51 level; if it fails, you can
expect a retracement or at least a change in trend.

Figure 4-22
Here are a few more examples of analyzing charts with multiple price gaps.
Bank of America’s chart (NYSE: BAC) displays the gap breakout level
technique of the first price gap that occurred in February 2008. Prices
decisively break through the breakout level to confirm
that this trend is bearish or, at minimum, that the move is going to continue.
Figure 4-23
Next, we use the Fibonacci gap measurement to determine the 2.618
multiple, which is where the market fell to and reversed.

Figure 4-24
Luckily, another price gap occurred in the beginning of this downtrend to
give us even more information. Because the breakout level for this gap was
confirmed by penetrating the price bar, you could probably have ruled out
the 1.618 downside target of the previous gap (see Figure 4-23) in favor of
the 2.618 downside Fibonacci gap measurement.

Figure 4-25
Interestingly, the Fibonacci gap measurement of the second price gap
(1.618) correlates with this projection as well. The two gaps form a range of
36.50 to 34.50, so that you could actually target both price moves. These
examples demonstrate that although the school of traditional technical
analysis relegates only a few paragraphs to price gaps, they actually hold a
world of information if you merely observe closely and apply what you’re
learning.
Figure 4-26
You can also apply the same Fibonacci gap measurement technique to soft
gaps. Figure 4-26 is a monthly chart of the Dow.
Figure 4-27
For the price gap marked by a red circle, measure the distance from the high
of the prior bar to the low of the following bar and extend the distance to
the downside to reach the 2.618 multiple — the memorable low in the Dow
in 2002/2003. Thus, you can see how price gaps are extremely significant:
They serve as psychological markers and include information that many
people either overlook or simply don’t understand.
Chapter 5
Price Gap Trade Setups
In this final section, we will focus on how to use price gaps to find trade
setups. I have devised two types of price gap trade setups to look for,
called the
double tap
and the
retest
. Over the years, I have also written
about them in my Trader’s Classroom column.

The Double Tap Trade Setup

Figure 5-1
The first price gap trade setup that I named the double tap (probably from
watching too much of
The Sopranos
on HBO) involves two tests of the
range of support and resistance defined by price gaps. In Figure 5-1, you
can see the red lines that denote support and resistance drawn off of the
three price gaps. Notice that Soybean prices travel into the range between
the two red lines (labeled test one) and then return to the range again later
(labeled test two). Here’s what makes this situation a trade setup: an
impulsive move often follows the second test.
Figure 5-2
Take a look at another example on this chart of Live Cattle. The support and
resistance test range is defined by the first green price gap and the third red
price gap. Test number one occurs in late April/early May, and test number
two follows a month-long rally out of the range. Again, the second test
leads to wave 3 of 3, a big impulsive move to the upside.

Figure 5-3
This Carnival Corp. (NYSE:CCL) weekly chart explains why I include soft
gaps in my analysis — although the chart spans almost two years, there are
very few hard price gaps. Nonetheless, even this one price gap marked by
the green arrow acted as a magnet for the market; the gap level was tested
twice as prices approached the blue line.

Figure 5-4
The double tap price gap trade setup can also work in a market traveling in
the opposite direction. Notice that I put my level (marked by the horizontal
blue line) at the close of the bar preceding the gap in red. The price gaps act
as magnets for the market and provide support and resistance for tests 1 and
2. The second test leads to the third-wave move or the wave 3 of 3 that
moves hard to the downside.

Figure 5-5
You can also combine the double price gap trade setup with the Fibonacci
gap measurement to successfully project price objectives. In Figure 5-5,
U.S. Bancorp (NYSE:USB) makes a small hard gap (in green) and then
returns to the range for tests 1 and 2. As usual, the second test sparks the
move up in prices. Next, apply the Fibonacci gap measurement technique
by measuring the distance from the low of the bar preceding the gap to the
high of the bar following the gap and multiplying it by Fibonacci levels —
1.618, 2.618, and 4.236. Our second test leads to prices traveling right up to
a 4.236 multiple, a move from $27 to $37. Now, that’s an amazing amount
of information to derive from one price gap.

The Retest Trade Setup

Figure 5-6
The second trade setup that uses price gaps I call the retest. It is simply an
attempt to close the price gap. Let’s see how it works on this daily chart of
Caterpillar (NYSE:CAT). The first step is to create a range off of the bar
preceding the bearish gap that we call the “Sell Zone.” Then look for a
move into this area, the retest, which is followed by a nice move to the
downside.
To take the same measurement for the first bullish price gap (in green), first
create a “Buy Zone” range off of the bar that precedes the gap, then look for
a move into the zone followed by a move to the upside.
Figure 5-7
Next, apply some of what you’ve previously learned to determine where the
market is going to go after the Sell Zone.
Looking at Fibonacci gap measurements, prices fell to a 2.618 multiple and
thereby registered a bottom. The gap breakout level technique showed that
the move to the downside after the second bearish price gap would not
continue. Once prices got above the range of the previous gap (indicated by
the 0.000 blue line), you had an inkling that the market was going to
continue higher. Prices came back then moved into the Buy Zone and
quickly reversed to the upside.
Figure 5-8
Let’s see how well the objectives did. A Fibonacci gap measurement of the
first bullish price gap (in green) in Figure 5-8 gives you the 4.236 multiple
as a target, which was almost reached.
Figure 5-9
A price gap breakout measurement of the last bullish price gap on the right
of Figure 5-9 provided a breakout level (marked by the top dark blue line),
and a Fibonacci price gap measurement analysis offered the 4.236 multiple
(marked by the lower dark blue line). Because the top did not reach the
range of these levels, there was no confirmation that the trend would
continue.
Figure 5-10
The weekly chart of Coffee in Figure 5-10 displays another example of the
retest trade setup. Note the two Buy Zones created by the ranges of the bars
preceding the price gaps.

Figure 5-11
Here’s how to determine if the market is going to continue higher:
Complete a gap breakout measurement of the second price gap in green.
Notice that prices could not decisively penetrate the breakout level (marked
by a blue line) and traveled back down near to the range of the bar
preceding the gap — the Buy Zone. After prices reverse, where is the
market going to go?

Figure 5-12
A Fibonacci gap measurement correctly projected the 1.618 multiple as a
target. The market then returned to the downside and tested the soft gap that
occurred earlier (marked by the extended blue line).

Figure 5-13
These examples have been in different time frames — daily, weekly,
monthly — but all have been from the same time period. How did this
technique work 10 years ago? This price chart of Walt Disney (NYSE:DIS)
from 1998 reveals that it works equally well. In short, I try to spend my
time and yours on techniques that work across the board. The first two price
gaps on the Disney chart do not penetrate their breakout levels, so you
know that the moves will not continue. The next price gap (in green)
decisively takes out the breakout level, and the Fibonacci price gap
measurement successfully identifies the 2.618 Fibonacci gap target. In the
later stages of the move, another small price gap (in green), provides a new
breakout level that is unsuccessfully tested, and the market reverses to the
downside. Similarly, prices don’t decisively penetrate the breakout level for
the next bearish price gap (in red). In April of 1998, another price gap to the
upside eventually pushes through the breakout level and right up to the new
Fibonacci gap target of 2.618.
Figure 5-14
Next, a gap breakout level measurement of the price gap following
penetration of the 2.618 level projects a breakout level at the 1.000 line.
Figure 5-15
Finally, a gap breakout measurement of the next price gap creates a range
for the breakout level. Because the price action does not decisively travel
above these breakout levels, you can expect the subsequent market reversal.
The prices then move down to the level of the price gap (in green) that
previously occurred around 3650, and bounce back up. That’s a powerful
display of how well this kind of price gap analysis can work in your
everyday trading.

Summary
Perhaps you can tell how much I like to work with price gaps. They are
easy to find and easy to work with once you get the hang of it. What always
amazes me is how much information price gaps pack into those two small
bars that act as psychological markers. Now that you have learned more
about them, I hope you will find it easier to work with price gaps to find
useful trade setups for yourself.

Chapter 6
Questions and Answers
Q. There are very few price gaps in Soybeans combined sessions chart.
Could I go ahead and trade the
combined sessions off of clear gaps on the day pit chart?
Kennedy:
Let me use an example of daily Soybeans.
Figure 6-1
As I stated before, I think that all price gaps are important. First, I would
identify levels on my Soybeans day pit price chart using a thin, lightly
colored line in order to remind myself that these price gaps provide a
certain price level in the market — 1378 and 131.
Figure 6-2
Then I would include those levels on a combined sessions chart (as in
Figure 6-2). However, because I think that the cluster of price gaps on the
left of this combined sessions chart is more significant, I would identify
them in a bolder color, as I did in red in this figure.

Now, you’re able to differentiate between the hard gaps in the pit and the
combined sessions, and ultimately identify a nice shelf of support in
Soybeans (circled in black). Again, I would identify the price gaps that
occur in the pit session in a subtle manner, because pit session price gaps
are basically the result of electronic combined sessions trading.
Q. What type of gap is Google in?

Figure 6-3 Kennedy

Based on the structure and the Elliott wave patterns, it appears to be an
acceleration gap. The largest move is marked by the long blue line, and
after the gap the market has a wave-three personality. In addition, notice
that there was an island reversal (a price gap to the downside followed by
a bullish gap to the upside) on the left of the chart. The market has the
signature of what I have labeled wave 1, wave 2, and wave 3, followed
by a pullback for wave 4. Now this is probably the first time I’ve looked
at Google in about three months, so I don’t know if this outlook makes
sense in the larger context.
Q. Could you discuss the weekly chart of the Dow Jones?

Figure 6-4 Kennedy:

To do that, I have to show you this chart with the
soft gap filter on it, because there are few hard gaps present. Although I
find the highest degree of reliability in hard gaps, you can still apply
many of the techniques that you have learned to soft gaps.
The market never penetrated the breakout level defined at the 1.000 level
for the first soft gap to the downside.

Figure 6-5
A gap breakout measurement of the next soft gap to the upside gives us a
breakout level marked by the higher dark blue line. In this case, it is hard to
determine whether the prices decisively penetrate the level, as each
following week fails to confirm a clear move up.

Figure 6-6
Hypothetically, if I had taken a position at this point, I probably would have
put my critical level for further rally or a stop on any kind of long position
at the low of the bar marked by the pencil.

Figure 6-7
After using the same technique for the next bullish price gap, you realize
that the market is unable to penetrate the breakout level and subsequently
travels to the downside.

Figure 6-8
Let’s skip over to the more interesting price gap (third red gap on the chart)
that gives us some breakthrough information. Because the 1.000 breakout
level is decisively penetrated, we will complete a Fibonacci gap
measurement next.

Figure 6-9
The market comes close to the 1.618 Fibonacci level a couple of times, so
we should analyze the next price gap to continue our projections.

Figure 6-10
Measuring the range of the bar preceding the gap gives us the breakout
level. Be cautious in your following moves. While the range of the last
week was very impressive, don’t pay it much attention; rather, focus on the
close of last week’s bar in relation to the breakout level.

Figure 6-11
We are now stopped at a very critical point. If the market is going to
reverse, this is a great area for it to happen. If not, and we do see a decisive
breakout of this level, then we can determine some objectives for further
downside movement, such as the 2.618 multiple in Figure 6-11.

Figure 6-12
A Fibonacci gap measurement of the last price gap gives us a 2.618
multiple as well. Thus, we can identify the range from 12,000 to 11,500 as
critical support for a possible price reversal. If this doesn’t happen, my
money is on further decline to the 10790 level initially.

Q. Is there an element of time involved with the gaps? For instance,

John Carter says that a gap on an index will move to close within 10
days.
 Kennedy:
I would have to say that it depends on the type of gap. A
breakaway or acceleration gap will most likely stay open longer than 10
days, whereas an exhaustion gap will probably close within 10 days. Now
I don’t like to throw out a static number like 10 days or to say that an
island reversal can take only three days, because the “rule of thumb”
tends to change shortly after you lock yourself into it. But if it’s
something that you see with a degree of reliability, then stick with it.

Q. What if the second test in the double tap trade setup is lower in a
bullish gap?

Kennedy:
Let me demonstrate this situation with a picture.
Figure 6-13
I’ve labeled the diagram in Figure 6-13 for you Elliott Wavers so that you
can see how price gaps, the double tap trade setup, and the Wave Principle
work together. In the first example (top image), the two parallel lines define
two hard price gaps, and prices enter into the range once for test one and
then at a deeper level for test two. In the second example (lower image)
prices enter the gap area for test one, but stop at a shallower point for test
two.
 Figure 6-14
How do you proceed from here? Look for a daily close above the levels
marked by red lines; this will signal the completion of your second test
and a trade worth considering.

EWI eBook
How to Trade the Highest-Probability
Opportunities: Price Gaps
By Jeffrey Kennedy, Chief Commodities Analyst, Elliott Wave
International
© 2010 Elliott Wave International

For information, address the publisher: New Classics
Library
Post Office Box 1618 Gainesville, Georgia 30503 US
www.elliottwave.com
ISBN: 978-0-932750-95-2