- Gaps occur in the forex market just as they do in the equity market, and a typical retracement pattern often forms hereafter.
- Here we discuss the different kinds of gaps, how to spot the moment when the gap is likely to be filled, and enter trades accordingly.
Gaps are more widely known within the equity markets, but they also occur in the forex market. Gaps are areas on a trading chart where a currency price has moved sharply up or down with little or no trading in between. On candlestick charts, a gap is represented by the large distance (space) between two consecutive candles. In other words, a gap occurs when a currency pair jumps from one bar to another with a considerable amount of price distance in between the bars. The most likely causes of gaps are lack of liquidity, volume, and market participants. In the forex market, these types of gaps often develop over the weekend, and can provide very good opportunities for profitable trades if traders can first interpret their meaning and then exploit the knowledge gained.
In this chapter I intend to show you just how to do this by first helping you understand how and why gaps occur and then showing you how to use them to make profitable trades.
Gaps are generated from fundamental (and to some degree technical) events. For instance, a fundamental event could affect the forex market by forcing a particular currency pair to open significantly higher after the weekend. Basically, there are four types of gaps which are:
Breakaway gaps occur at the end of price patterns and signal major reversals or new trends.
Exhaustion gaps develop near the end of a price pattern and are produced by the price attempting one last effort to hit a higher high or a lower low.
Commons can happen at any time and are not associated with any particular price pattern.
Continuations occur in the middle of a price pattern and are normally generated because market sentiment regains faith in its belief of the initial direction of the price channel.
The expression, ‘the gap is filled’ applies when the price has reverted back to its original pre-gap value. This happens frequently because over-zealous trading may have produced a price spike that then needs correction. Traders have developed a number of forex trading strategies to help them profit from gaps. eHere are a few of them:
Monitoring fundamental news over the weekend can be a profitable activity especially if you are able to detect any major discrepancies from the events of the previous week. If you achieve this, then try to determine the reasons behind the differences. If the forex market then commences the new week showing the expected gap, you will be in a good position to enter a trade that will either support or to fill it depending on the results of your analysis. Do beware though that once a gap starts to fill, this process will rarely stop as there is no immediate support or resistance to prevent it. In addition you must accurately determine which type of gap you are dealing with. This is important because exhaustion and continuation gaps trade in different directions. Gaps are normally caused in forex trading by the speculative small trader who exhibits more irrational exuberance than the large institutional investor.
Here is a basic gap trading system developed for the forex market which uses gaps to predict retracements to prior price levels. This strategy consists of the following rules:
The trade must always be in the direction of the trend. The currency must then gap significantly above or below a key resistance level on a 30-minute chart before retracing to its original resistance level. As a result, the gap would then appear to be filled and the price has returned to its prior resistance which has now turned to its new support. You must then wait until you can clearly identify a candle that signifies the continuation of the price in the original direction of the gap. This action helps ensure that the support has remained intact and presents an excellent entry condition for a new trade with a very good risk:reward ratio. In addition, you are always well advised to place a stop which in this case should be positioned just below the new support level at least. I prefer to locate potential entry points near either strong supports or resistances but always open them a couple of pips above or below in order to provide some order of protection against fakeouts. I then select a target level to match close to the gap end.
Gap trading is nothing new and has been used in both the stock market and commodities trading for decades. Traders have taken the advantage of the difference, or "gap" between the closing price of the day before and the opening price of the next day. However, this strategy is not commonly used by forex traders. The reason for this could be that gaps rely mainly on a market close. As the forex market never closes except at the weekend, generation of gaps is much rarer. In fact, during an entire trading week, there is only one time when using a gap trading strategy in the forex market is possible. This is at the re-open on Sunday. However, although you may think that this presents too few chances to trade gaps, what you must realize is that forex gap method is associated with a very high success rate in the order of 85%.
So what is the best way to trade Forex gaps?
The first important point to understand is that there are only three possible ways that price can change over the weekend.
- The price can open above Friday's close called "gapping up".
- The price can open below Friday's close called "gapping down".
- The price can open at the exact same price meaning that no gap has been generated.
Large gaps are named full gaps while small gaps are known as partial gaps. A good gap trading strategy works for all types of gaps except many gap traders usually dismiss those smaller than 15 pips in size. They also tend to prefer trading just the major currency pairs.
The main rule to gap trading is quite simple. Whichever way the gap is growing, you open a trade in the opposite direction. In other words, if the gap is rising, sell short otherwise if it falling, buy long. You will be surprised how often this simple strategy works and it could provide you with the foundation on which you can successfully build your forex trading.
Again, you are advised to test your new gap strategy out by calculating its expectancy value and win:loss ratio using either a demo account or a live account using minimum lot values. You also need to have a feel of the market; you cannot simply enter a trade the second you see there has been a gap. You always need to look for support and resistance levels and use appropriate money management. If you have a gap of 100 pips it might be not be the best idea to enter a trade with a 10 pip stop loss. I know you would like to have exact rules on when to enter and exit, and how many pips away your stop loss and target should be, but the sad thing is that there is no certain rule which can be equally applied to all situations. You need to learn how the market reacts.