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Price gaps, which are very common in the financial markets, occur on charts when no overlap exists between consecutive period highs and lows. If XYZ stock’s high is 81 and its low is 80 on a given day, for example, and the next day, it opens higher than 81 — let’s say 83 — and trades in a range between 82 and 84, a gap with no trading exists between 81 and 82. That stock gapped higher and never closed the gap. If the stock had opened much lower — 77 or 78, for example — and never reached the previous day’s low, it would have gapped lower.

So what causes price gaps? These gaps are usually the result of news about a certain security being released outside market hours. This situation isn’t uncommon: Most companies release their quarterly earnings or other big news either after the market closes or before it opens. The market adjustment to that news causes price gaps. Also, a gap may occur on specific stocks just because they’re moving up or down due to a gap in the overall market. The gap may occur due to the release of some economic news before the market opens or possibly due to a macro event such as a terrorist attack.

You should remember that gaps always get filled when the high to low price action of a future day covers the price range where no trades occurred. But you can’t always tell when gaps will be filled. When the dot.com bubble was building, some Internet stocks had several price gaps on their way up to stratospheric valuations. These gaps were eventually filled, but anyone who was trying to short these stocks for the gap being filled would have ended up in the poorhouse before any gap-filling took place.

FIGURE 2-4: A common candlestick sell pattern.

The pattern is a two-day pattern, and the third day is a common reaction to the first two days. Here’s the typical progression:

1 The first day is a strong open-to-close day. The closing price is considerably higher than the opening price. The first day is a victory for the bulls.

2 The second day reveals very little price action because the close is very near the open. The second day is a wash because higher prices entice more bears to be sellers.

3 After this shift from bullish to neutral price action, the following day is a down day. The third day is a winning day for the bears!