Gaps primarily occur over the weekend because it is the only time the forex market closes. Gaps may also occur on very short timeframes such as a one-minute chart or immediately following a major news announcement. A gap is a change in price levels between the close and open of two consecutive days. Although most technical analysis manuals define the four types of gap patterns as Common, Breakaway, Continuation, and Exhaustion, those labels are applied after the chart pattern is established.
The forex market never closes, not even on weekends or holidays. A common misconception among forex traders is that the market is closed over the weekend. In fact, only retail trading is closed on weekends. The forex market as a currency exchange is alive and well. Which brings us to an important discovery about gaps – they don’t exist. At least not in the way a lot of folks like to think they do, which is that a gap is created by the market. Instead, it is actually your broker that is responsible for the gaps you see on your charts.
The most common way to trade a gap is to assume that it will get filled at some point. In other words, you would enter the trade when the gap appears and target some point inside the gap. Some traders target half the gap, just to be safe, while others target the whole gap. The method you choose will depend on the pair you are trading and what testing has told you works the best. Where to set the stop loss isn't as clear and will take some testing and experimentation.
The first big factor to consider when trading gaps is to ensure you have enough of a profit margin. In the case of the Common Gaps or Breakaway Gaps, the actual gap needs to have a decent size otherwise the risk to reward ratio suffers. In this regard, you should only look to trade gaps that are at least in 40-50 pips range. If the gap doesn’t get filled in the first few hours there is a high probability that the market will most likely continue in the direction of the gap. Once you get more familiar with the different types of gaps and you will understand them better, and you will be able to frame your own strategies on gap trading.
When trading gaps you should be trying to read the context available to you – a breakaway gap is not going to be one that’s a good idea to trade against for example. Then just because a gap is likely to be closed in the session doesn’t mean you’ll know when it is going to close. If the EURUSD gapped up 30 something pips and you just sold it immediately, it could go another 100 pips higher and stop you out before turning down to close the gap. So you need to select the right gaps to trade and you need to identify when the market activity is telling you it wants to close the gap.
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