Understanding Stocks

LET’S GET TECHNICAL: INTRODUCTION TO TECHNICAL ANALYSIS 127
3. The exhaustion gap. This shows a stock that gaps up or down but
doesn’t reach new highs or lows. As a result, it is likely that the
price move will fail (or be exhausted), and the stock will immediately
return to fill the gap (retreat to the earlier price). If you
identify an exhaustion gap, get out as quickly as you can.
Some short-term traders are skilled at playing gaps. For example, if
you were fast, you could have bought IBM on the market opening at
$86 a share and sold it a few minutes later at $88, for a 2-point gain.
This is the kind of play that short-term traders live for. Unfortunately,
many stocks will gap up or down and suddenly reverse direction to fill
the gap. Keep in mind that trading on the basis of gaps is a difficult
maneuver that takes a lot of practice if it is to be successful.
For example, suppose that when the market opens for trading, the
S&P or the Dow index has gapped up (or down) substantially from its
previous close. Skilled technicians will “buy the gap up” but keep a
tight stop. Others will “fade the gap,” or trade in the opposite direction
from the gap.
As mentioned in an earlier chapter, if you are a first-time trader, it’s
best to avoid making trades as soon as the market opens. This is when
professional traders dominate the market playing field, using large
sums of money to move stocks in one direction or the other. Making
trades based on gaps is best left to the professionals.
Problems with Technical Analysis
Critics of technical analysis claim that reading stock charts is similar to
telling your fortune using tea leaves. They claim that it’s impossible to
make predictions about the future based on what happened in the past.
Tomorrow is all that matters, according to the critics. In addition, critics
claim that there is no proof that technical analysis actually works.
Perhaps the only way to find out for sure is to try it for yourself. Just
like fundamental analysis, technical analysis is as much an art as a science.
It takes an extremely competent and dedicated technician to find
good stock picks using technical analysis.