Technical Analysis and Gap Theory on SPY

What is a gap?

A gap refers to a difference in price between the closing price of SPY on one day and the opening price of SPY on another day. For example SPY closed at 119.87 on 4/13/2010 and opened at 120.28 on 4/14/2010, so the gap is 120.28-119.87=0.41.

What is so special about gaps?

All gaps are eventually filled. It may take an hour or it may take a year but all gaps on SPY are eventually filled. So if SPY gaps up in price one day then you can expect SPY to drop and "fill the gap" in the future. But you never know how far in the future the event will occur. The best you can do is to use technical analysis to determine the probability of a gap fill.

How do you use technical analysis to determine whether a gap will be filled or not?

Well before I get into technical analysis, here is a rule of thumb about gaps: The smaller the gap, the more likely it is to be closed. For SPY I draw the line at 0.5. If the price gap is larger than 0.5 then usually that price gap is not closed on the same day that it is opened and it is not worth playing for a gap fill. The most famous example of a huge price gap was during the stock market crash of 2008. On Friday, 10/3/2008 SPY closed at 110.34. On Monday, 10/6/2008, SPY gapped down and opened at 107.15, resulting in a price gap of 3.19. This large gap was not closed until 11/11/2009. It took over a year for the gap to fill.

Technical Analysis of Gaps

In the chart below, 119.87 is the price level that SPY must drop to, to "fill the gap," I typically call this price level the "gap fill target." On the other hand, 120.28 is the price level that SPY opened at to create the gap. I typically call the 120.28 price level "gap support/resistance."

The first thing to know is that gap resistances/supports such as 120.28 do not always serve as levels of resistance or support. Since SPY is greater than 120.28, the price level of 120.28 may serve as a support level. In this chart 120.28 does indeed look like it is serving as support since SPY has been unable to convincingly break through. If SPY does drop to 119.87 and fills the gap, then don't expect the gap fill target at 119.87 to serve as support. Instead you have to identify the next technical support level. I have done this and have identified 119.8 as the next technical support level below 119.87. So if SPY drops to fill the gap then I would expect SPY to find support at 119.8, not at 119.87. If SPY did find support at 119.87 then I would look for evidence of 119.87 being a technical support level as well as a gap fill target.

What happens if a technical support/resistance level is in between a gap?

This occurs frequently. The rule of thumb is that technical support/resistance levels take precedence over gaps. So if there is a technical support level in between a gap then you have to expect that SPY will bounce at the technical support level. This means SPY might not completely fill the gap! In this case the gap remains open and SPY is still expected to drop to fill the gap in the future. In the chart below, SPY drops to fill the gap but runs into a technical support level at 117.1, leaving the gap open. In the future I expect SPY to drop back to the gap fill target at 117 to fill the gap.

Gaps and Day Trading

For day traders, if a gap is not filled by 11:30EST then the chances of it being filled later in the day drop significantly. Trading volume drops off after 11:30EST and doesn't usually pick up until around 2:30EST. And sometimes the trading volume does not pick back up. For day traders the most important hours of trading are between 9:30EST-11:30EST, if a gap is not filled within that time period then the odds of the gap being filled on the same day drop precipitously (though it has happened before).

Gap Theory Applied to Other Stocks

I apply gap theory on SPY on a daily basis and all the advice I have written about applies mainly to SPY. The reason is works so well on SPY is because SPY has a large daily volume typically 100M to 200M. Most stocks do not have this kind of daily volume. Gap theory does not work well on stocks with low volume (<1M). It also does not work on leveraged exchange traded funds. (Technical Analysis in general should not be performed on leveraged exchange traded funds, instead do technical analysis on the underlying indexes that make up leveraged exchange traded funds). Furthermore gaps in individual stocks can be much much more dramatic than on SPY. For example a company can report terrible earnings and drop 20% at open. For these kind of gaps you have to allow for a much longer timeframe to fill the gap than on SPY. Overall I do not apply gap theory to individual stocks very often.

Final Remarks on Gap Theory and Technical Analysis

Gap theory is very powerful technique and helps determine short-term, and in some cases long-term stock market direction. If there is any other question that I have left unanswered about gaps, then contact me at spycharter@gmail.com and I will update this page.