Gaps at the Top Reveal Exuberance

Gaps at the Top Reveal Exuberance

“Each problem that I solved became a rule, which served afterwards to solve other problems.”

Exuberance at the top is depicted with the formation of long candles or a gap up. When either or both of these situations occur, be prepared for a candlestick sell signal to soon follow. This becomes a simple visual analysis. Being able to correctly interpret the investor sentiment conveyed in a gap up at the top be­comes an important decision-making factor. Fig. 4-23 (following page), The Nike Inc. chart reveals a gap up followed by strong buying when stochastics is well in the overbought area. The following four or five trading days indicate indecisive movement between the Bulls and the Bears at those high levels. The big trading day either revealed that something major was happening in the stock price or it was the final exuberant buying. The fact that the next five days showed indecisive trading, no bullish follow through, now provides a better picture of what is happening to investor sentiment.

Described in the “Stop Loss” chapter later in the book, effective stops can be placed upon a gap up in overbought condition. Simple techniques allow for reaping the majority of the potential returns from a trend.

When prices gap up in overbought conditions the potential for forming a candle­stick ‘sell’ signal becomes favorable. Prices backing off from those levels can form a Dark Cloud or Bearish Engulfing signal if they continue weak for the rest of the trading day. Even if prices come back up to the top of the trading range, a signal such as the Hanging Man or a Doji could be formed.

If prices continue higher, and pull back by the end of the day then a Shoot­ing Star can be formed. Once a gap up occurs, the only possibility of a candle­stick sell signal not appearing is when prices open higher and then continue to trade to the higher end of the trading range. If this is the case, the placement of stop losses, as recommended in the “Stop Loss" chapter, will not be affected. Profits will continue to be made. However, the point of being prepared for a gap up at the top is based on probabilities. The “probabilities” a trend is over is much greater than anticipating the trend going higher.

Fig. 4-24, The XM Satellite Radio Holdings Inc. chart illustrates that the sellers are ready to take over, after an extended uptrend that is followed by a gap up. Unless something dramatic is about to occur, such as an announcement of good news for the company, it is likely that the uptrend is over. This assumption is based upon the visual observations over the past few centuries. Why invest against the probabilities?

If the gap up is substantial, and it continues higher, put the stop at the open price level. On any of the scenarios described, the price moving back to the ‘stops’ would more than likely create signals that warranted liquidating the trade, forming Shooting Stars, Dark Clouds, Meeting Lines or Bearish Engulf­ing patterns. In any case, sellers were making themselves known. It is time to take profits in the high-risk area and find low risk ‘buy’ signals at the bottom of a trend.

The candlestick investor requires nothing more than the training of the eye to recognize high probability patterns. A large gap up in an overbought condition provides a definite decision-making process. As a rule, the appear­ance of exuberant buying is the time to be prepared to take profits. The ques­tion that should always be asked, “When prices are going through the roof, when the accompanying news appears to make the future look very bright, who is selling?”