Chart Term Misconception & What Price Closes a Gap
Chart Term Misconception & What Price Closes a Gap
Having been around the trading arena for many years, I have seen many changes to the world of trading. One of them has been how many new technical indicators and chart patterns have been introduced. When I started trading, we probably had 4-5 technical indicators, and perhaps 10-12 reliable chart patterns. Today, you can look at any charting software package and see hundreds of different indicators. They all still use the same data points that were used when we only had a handful of indicators:
- 105 Candle Patterns
- 100 Chart Patterns
- 20 Elliot Wave Patterns
This is like giving your child a name at birth and then on his 6th and 12th birthday, you change their name. It's the same child, but you are going to expect them to respond to a new name every couple of years. Plus, everybody who knows your child now has to learn the new name for the same child.
Two of these patterns that seem to have a misunderstanding are the inside day and the outside day. We will look at these two and show you what the proper terminology is for each of these.
The inside day is a pattern that finds the market in a state of balance where buyers and sellers are unable to push the price outside of the previous day's high or low. Figure 1 demonstrates this pattern.
Figure 1 shows how the two bar pattern in the aqua eclipse is formed. An inside bar (B) has a lower high and a higher low than the previous bar. The green bar (A) shows how the buyers were in control of the market during that period by pushing prices to a new high over the previous bar. The green bar (B) shows how the supply and demand can become in balance. At this point, there is no conviction in the market for going higher or lower. We must wait until the high or low of the bar is penetrated before we can tell who wins the supply and demand battle.
When price bars become compressed like the (B) bar, we tend to see range expansion on the next bar. If you can find an inside bar pattern like this at a support (demand) or resistance (supply) level, you have a very good setup for a trade entry. If the pattern is located in the support/resistance zone, we would place an entry buy stop above the high of bar (B), and can then place a protective stop under bar (A) low.
The color of the bars makes no difference when identifying this pattern. We look at the extremes of the wicks to determine the high and low of the bars.
The other pattern that seems to have some ambiguity is the outside bar. Figure 2 shows the outside bar pattern.
The outside bar pattern is composed of two bars. The first bar (A) is smaller than the second bar (B). Bar (B) has a lower low and a higher high than the previous bar (A). I have been hearing of outside bars being defined as only the high or the low of bar (A) is penetrated. This is not the traditional definition of an outside bar. Both the high and low of (B) must be beyond the previous bars (A) high and low.
The key to a successful reversal is the bigger the outside bar (B), the better. Also, if you see this pattern at the end of a trend, it has much more meaning. Look for the close to be in the opposite direction of the trend. A popular name for this pattern in candlestick terminology is an engulfing candle.
Outside days are simply signs of increasing volatility and don't offer directional clues. However, if the outside day is much larger than the previous trading day's, you can usually expect the next day's trading to be a mean reversion style of trading. One of the best setups is for the outside bar to close on its extreme high or low, then gap open the next day into a support/resistance area. These types of gaps are filled on a high percentage of occurrences.
I hope this helps to clear up some of the misconceptions of how to identify these two very popular chart patterns. Once we all start calling these patterns by their intended names, I feel we will begin to recognize them more frequently. Then we can use them to profit from in our arsenal of trading tools.
The other event that just happened recently is a case where the ES (E-mini S&P) stopped trading at 4:15 PM EST like it always does on August 31st, 2010. Then the market settled its final price of the day about 4:25 PM EST. Normally these prices are only off by one or two price ticks. This time there was a relatively large difference. If you look at a day session chart, you see the last price trade at 4:15 PM EST was 1052.50. Then if you look at a daily chart for that same day, you see the settle price was 1048.25.
Each Futures contract has a closing price, then there is a settlement price that is established by the exchange. Usually, this settlement price is established during the last minute or so of trading each day. The exchange uses the range of this last minute and then figures out the price where the most contracts traded at, and this becomes the official settlement price for the day.
The reason I bring this to your attention is that if you were marking your gaps on the chart, you could easily place the gap line at the wrong price. I would strongly recommend that you always look at your daily chart price, and not an intra-day chart for actual settlement prices.
If you use the floor trader pivots on your charting software, you should also check to make sure the levels are correct. I noticed on a particular trading platform that they were off by several points on the next trading day because of the large difference between the last price tick on the chart and the actual settlement price.
- Don Dawson
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