Gap Down at the Bottom

A Gap Down at the Bottom

The basic premise of investing: buying at the bottom. Candlestick analysis pro­vides the tools for exploiting human emotions. The fear that enters most inves­tors investment decisions can usually be seen graphically on a candlestick chart. The evidence is usually illustrated with the candle bodies getting larger as the price enters into the oversold conditions. This is often seen after an extended decline. The further the downtrend moves, the more panic selling is observed.

The panic selling is usually fueled by the rhetoric put out by the talking heads on the financial news stations or the financial publications. Most of the time the financial news agencies are reporting what has already happened. After a stock or any other trading entity has been in an extended decline, it starts getting discussed in the news media. The discussion for why that indus­try/sector is in such bad condition starts getting publicized, alter it has been in a three-month downtrend.

Quite often when a trend, whether positive or negative, becomes recog­nized by the financial news repotting media, that is usually time to start watch­ing for reversal signals. Very rarely will you see reports from the news media stating why an industry would likely be attractive after a severe decline. They always seem to report why things are bad after the price decline has occurred. This becomes a great indicator for watching for a candlestick reversal situation. When you hear constant doom and gloom predictions for an industry; prepare for the panic selling. Then start watching for the buy signals.

“An investment in knowledge always pays the best interest.”

What is the ultimate indicator of the panic selling? The gap down at the bot­tom! A clear indication, illustrating investors wanting to get out of a position, no matter what the price! The gap down illustrates the tremendous desire (panic) to exit from that position. A gap down in oversold conditions becomes the cause for diligently watching for a candlestick ‘buy” signal to occur. If most investors panic at the bottom and a gap down represents the panic selling, then the bottom is usually very nearby. This is purely common sense. Having this knowl­edge of investor psychology allows the candlestick investor to be prepared for the “buy” signal.

Does that mean a buy signal will show up immediately? Not necessarily. However it does indicate that the majority of the move in the downtrend is probably over. This creates two benefits. First, if this position had been shotted, it now reveals a time to start covering the short position. Second, it alerts in investor to start watching for a buy signal.

As illustrated in Fig. 4-14 the Powerwave Technologies Inc. chart, after an ex­tended downtrend the selling starts escalating. This is identified with a large black candle followed by a gap down in price. That gap down forms a Doji/ Spinning Top. With the stochastics well in the oversold condition, the gap down should have been the first inkling that the bottom was near. In the Powerwave Technologies Inc. chart, the gap down Doji was the end of the majority of the downside move. About a week later, a gap up after the Hammer signal indi­cated the uptrend may have started.

The point of this illustration is to show that the gap down at the bottom war­ranted closing the short positions and watching to go long.

As witnessed in Fig. 4-15. the Raymond James Financial Inc. chart, the stochastics had indicated that the price of the stock was in the oversold condition through­out early July until early August. During that time there were a number of potential candlestick buy signals but the signals never got confirmed. Note how the ultimate bottom occurred after a gap down.

A big selling day, after a gap down when stochastics have been in the oversold condition for a lengthy period of time, becomes the alert to start watching for a candlestick buy signal. The Bullish Harami, the following day becomes a clear indication that the last gasp selling was over and buying was starting. A gap up the following day creating an island reversal, becomes a very strong reversal indicator. This whole sequence would have been put on watch because of the gap down.

Fig. 4-16, the Monster Worldwide Inc. chart, also illustrates the final bottom. It is not unusual to see increased volume coming into trading after a gap down. This becomes an indication that the weak are selling to the strong. Although the volume is not a necessity, the presence of a large volume day during the gap- down day, or a day or two to one side or the other, reveals that there has been a large change of ownership in a stock. The weak sellers have relinquished their stock to the strong.

The Spinning Top/Harami appearing during following day illustrates that the selling had stopped. The uptrend may not start immediately. There always exists the possibility of some follow-through selling from the previous down­trend. However, a gap down signifies that most of the selling occurred that day. After a few days, the rest of the selling becomes acquired by the buyers. Then the trend can get started to the upside.

The gap down at the bottom doesn’t necessarily mean that a strong uptrend will occur, but it does signify that the downtrend has stopped. Fig. 4-17, The Eyetech Pharmaceuticals Inc. chart illustrates, after an extended downtrend, the gap down at the bottom revealed that the downtrend had stopped. At that point, watching for candlestick ‘buy signals becomes the strategy. Those ‘buy1 signals may not show up for a few weeks, but the probabilities that the bottom is near becomes extremely great when witnessing the gap down in the oversold conditions. This may not be the time to buy. However, if an investor had been short this position, the gap down would have been the signal to take profits.

Keep in mind, a gap down near the oversold area indicates that a bottom is near. That is why it becomes important to analyze the candlestick signals that are forming.

As in the case of Fig. 4-18, Sonic Solutions Inc., the gap down on large volume was near the bottom. It took a few more days to wash out all the sellers.

The Doji/Harami, followed by the gap up bullish candle, became a ‘buy" signal. After an extended downtrend, all the selling sentiment will not disappear on one major down day. Likewise, the selling doesn’t always immediately disap­pear after a strong bullish candlestick ‘buy’ signal. This knowledge permits a candlestick investor to sit through a residue selling day or two after seeing a reversal situation occur.

The subtle gap downs become more apparent when a candlestick signal forms on the gap down day. Notice in Gig. 4-19, the Cleveland Cliffs Inc. chart how the gap down may not have been noticed had a Doji not formed that day. Of course, a Doji at the bottom should always be heeded. When the stochastics have confirmed the oversold condition, the slight gap down on the open of the Doji signal becomes more important.

A gap down on big volume should become a well-recognized sign. It incorpo­rates all the investor psychology required for identifying when investors are getting out at the bottom. It usually occurs on bad news. That news probably was known to the smart investors months before. More titan likely they were selling at the top. The information was built into the decline of that stock price months ahead of when the announcement came out.

Fundamental analysis should be used when exploiting the gap down at the bottom. Whatever bad news was reported, fundamental analysis assumes that the management of the company was aware of the problem well before it was announced. It also has to be assumed that a high percentage of manage­ment teams are relatively smart and effective

This assumption is made based upon the fact that most management execu­tives rise to their positions based upon talent. With that in mind, then it can be is assumed that by the time that a bad news announcement is made, the prob­lem is being resolved. The management of that company had been working on the solution to the problem for at least a few months. By the time the news comes out, a resolution to the problem may already be in place.

That leads to one final question. If everybody is panic selling at the bot­tom, and the circumstances looks bleak for that stock, then who is buying? If you have ever found yourself selling at the bottoms because your emotions cannot stand the stress and the strain, then you should recognize where you sold in the past. Use that knowledge and the understanding of what a gap down at the bottom represents. Once you can visually identify indications of bottoming action, an investor can now establish being mentally prepared to buy when the rest of the world seems to be selling.