By Sean Hannon, CFA, CFP, of EPIC Advisors from Covestor.com
In the past, I have discussed how I like to use simple technical patterns to determine trading targets. Among my favorite indicators are trend lines, triangles and fans. This week I examine another powerful tool: Gaps.
A gap occurs when a stock price opens at a level that is much different than the prior day's close. For example, if shares closed the prior day at $15 and opened today at $20, we would view this as a $5 gap higher. Once a gap occurs, the prior day's close ($15 in this example) becomes a key level of technical support.
When prices gap higher, the gap becomes support; when prices gap lower, the gap becomes resistance. Until this new support or resistance level is violated, the underlying trend remains intact and allows us to trade accordingly.
Examining a chart of DryShips (DRYS - Get Report), multiple technical patterns emerge. As the worldwide recession spread and deepened, shipping rates collapsed -- DRYS' price quickly followed. From a high point of $110.74 in mid-May, the stock traded to a low of $3.54 in late November. This stunning 97% drop over six months created a clear downtrend that was rarely tested.During this long decent, we saw three gaps lower: from $55 to $50 (9%) in mid-September; from $31.50 to $28 (11%) in early October; and from $18 to $15 (17%) in late October. Each time the stock gapped lower, the gap served as resistance to future rallies. Since bottoming on Nov. 21, we have seen three gaps higher: from $9.50 to $11 (16%) on Dec. 10; from $12.50 to $13.50 (8%) on Dec. 18; and from $10.50 to $11.65 (11%) on Jan. 2. These levels now serve as support that should allow the stock to trade higher. Importantly, the last gap higher has broken the long-standing downtrend and has allowed DRYS to close at its highest level since bottoming in November. Combining all the technical signals, we see a reversal in the share price that will allow for a sustained move higher.