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Mind the Gap- Options Trading Technics

  
 

Gaps are like shooting stars, with their high, low, open, close, above or below the preceding days.

Gaps play a major role in technical analysis. The formation of a gap can be any of the candlesticks mentioned above. Gaps usually set a new pricing for the financial instrument; once this new price in place most likely prices will not recoil in the near future.

For example, if the FDA approves a biotechnology company’s drug for mass production, by estimating sales and profits, market participants price the company to a new higher price; most of the time the two prices will form a gap. The company's new price will set grounds and henceforth, as long as no radical or controversial news emerges, the future will judge the company by its performance.

Here is a second example. In normal times (although there is no such thing as normal timeslet us say, relatively normal times), let’s look at an ETF issued by iShares Barclays (TLT). The ETF is a 20+ Year Treasury Bond Fund (the Fund), formerly iShares Lehman 20+ Year Treasury Bond Fund, and seeks to approximate the total rate of return of the long-term sector of the United States Treasury market as defined by the Barclays Capital 20+ Year US Treasury Index (the Index). The Index measures the performance of public obligations of the United States Treasury that have a remaining maturity of 20 or more years, are rated investment grade and have $250 million or more of outstanding face value. In addition, the securities must be denominated in United States dollars, and must be fixed-rate and non-convertible securities. The Index is a market capitalization-weighted index. The Fund generally invests at least 90% of its assets in the bonds of its Index and at least 95% of its assets in the United States Government bonds.

Normally if the fed funds rate changes, TLT changes accordingly under the consideration of other exogenous inputs such as cross-rates and economic indicators. However, what will happen if the Federal Reserve changes the interest rate in an unexpected pace, TLT prices will gap up and stay above the new price for a while.

  
   TLT gap up- Technical analysis
TLT gap up- Technical analysis
Symbol; TLT, Daily data collected from Sept2008 to Jan2009		  
 

The year 2008 remembered as worst year and a turning point in the global economy. Worst because of the fathomless uncertainty in the financial markets and a turning point because of new regulations, that will take place to prevent a second catastrophe. See further elaboration in a footnote. However, the Federal Reserve started cutting rates to the lowest rate ever in the history of financial markets. These cuts led to rapid increments in the 20 years treasuries face value and formed gaps. In the first gap, face value tested gaps low and then rebounded.
Prices after the second gap rapidly increased. The third gap is black and these means that, at that point, sagacious traders disagreed on the market price and understand that prices cannot go any further up, also, taking under consideration that financial markets are in a most critical condition, gradually, they sold their profitable positions.  Additional point of view, prices relatively drifted away from the 50 days simple moving average and according to the phenomenon, prices tend to converge to the mean occurred several days after followed by relatively high volumes right at the top of the graph.