Imagine a congestion zone (i.e. nothing interesting is going on) and after it the price breaks up with a gap. Then the price continues in the upward direction. Such a gap is called a breakaway gap and an example is shown in the figure below:
(Nike in 2013. Source: NinjaTrader)
The congestion zone is associated with some uncertainty in the market, i.e. the price does not really go up or down as there is a sort of equilibrium between the powers of bulls and bears. Therefore, a breakout from this area combined with a bullish gap confirms the buying pressure. This indicates that we should also enter.
In order to check the performance of this pattern, I created a computer program that identifies these types of gaps on price charts. The figure above presents also a long entry after the program detected a breakout gap. Please note that we buy the stock on open of the next day after the breakout occurred.
The blue circle that you may spot in the graph is the stop-loss location. This is simply a point with a local minimum in price (the stop-loss is placed a few cents below this lowest price).
The take profit level is not really specified when trading breakaway gaps. In practice, a trader may consider e.g. some resistances above or just trail the stop. For backtesting, however, I did it much simpler and assumed that the reward/risk ratio had to be equal to 1.0. It means that the take-profit price is the close of “yesterday” (i.e. we buy “today”) plus the distance between the close of yesterday and the local minimum (i.e. the blue circle). For illustration, it is shown in the figure (note that distance h).
The objective was not to show a full trading strategy but rather to investigate the price action after the breakaway gap. Further, I assume the gap size to be at least 1% of the stock price and the trading volume on the breakout to be at least twice the average of the past 14 days.
Here are the results of backtesting on the stocks from S&P 500 index:
|Number of trades||473|
|Average time in market||61 days|
And the same for Russell3000:
|Number of trades||1202|
|Average time in market||65 days|
The strategy gives quite good results. Note the relatively low maximum drawdown and a very high percentage of profitable trades (even 74% for S&P 500 stocks). In real trading we can even improve the performance by considering bullish action, adjusting the take-profit price etc.
If you are interested, I published more results in the following article:
Kosinski, Pawel . “Treading Breakaway Gaps,” Technical Analysis of Stocks & Commodities, Volume 37: March.