A gap on the chart looks a lot like a skipped heartbeat, which it kind of is. However, in reality it isn’t as bad as it might sound. In fact, a fair share of trading strategies are built on the idea of gapping. Today we are going to discover the nature of market gaps and find out how to trade gaps successfully.
How to Find a Gap in Trading Prices
First things first, how do the gaps occur? Depending on the market, gaps might form at different frequencies with different levels of severity. On Forex, gaps don’t take place as often as in the stock market, but it is nevertheless important to know why they happen and how we can benefit from them.
The top reason for chart gapping is that although retail traders are active 24/5, the Interbank market is live 24/7, which results in price differences significant enough to create an empty space in the price movement. The gaps are the most visible on either a candlestick or a bar chart. When a new element is formed visibly lower or higher than the previous one, with nothing between them: that’s a gap.
There are several general types of gaps: common, breakaway, runaway and exhaustion. Common trades are considered the most comfortable for currency trading, and we will circle back to them further on. Breakaway gaps happen when the price rapidly breaks out of the established trading range. The two contributing factors to such a gap are the increased enthusiasm and the dominance of bulls versus bears or vice versa. The volume always picks up significantly after breakaway gaps partially due to the new flow and partially because of everyone who held opposite positions, changing direction to match the surroundings.
Runaway gaps are similar in appearance, but slightly differ in nature. They occur when the interest in the currency suddenly increases, for example after an economically significant announcement. Runaway gaps happen in both uptrends and downtrends, but in downtrends they are associated with increased interest of sellers rather than investors. A big part of how to trade gap downs, is understanding that they are always associated with higher risks of not selling at the price you wanted, therefore, proper risk management techniques should be implemented.
And finally, exhaustion gaps happen with the loss of momentum towards the end of an ongoing move. Along with prediction patterns, exhaustion gaps are primary indicators of an ending trend. Now, let’s get back to the common gaps in order to understand how to trade gaps in Forex effectively.
How to Trade Forex When There is a Gap
Before we go into how to trade Forex when there is a gap, let’s begin by defining common gaps. Such gaps normally appear at late Sunday and early Monday opens, due to the exact reason mentioned above: discrepancy between the time retail traders and Intrabank are active. Common gaps might also form after holiday breaks, such as during winter season. The presence of significant to the market news announcements is very likely to cause a gap.
A very effective solution to how to trade gaps successfully on the example of a common gap goes like this: locate the gap and use the chart you found it on for your setup and spot the first candle after the gap (high or low depending on the gap). You will have two entry options: immediate entry or conservative entry, at the break of the first candle’s high or low, once again depending on the gap and on the position you are about to hold. Place your stops as you normally would’ve and aim for the take profit around the same level where the gap began.
Provided you choose a pair with enough volume, you will be able to reach the desired results rather quickly. Now, let’s briefly look into how to day trade gap up and gap down in closer detail.
Daily Gap Down
If you decide to trade down gap at opening, make sure you go with the highly volatile pair, this will give you a better chance for experiencing a note-worthy gap. Then, after you locate the gap, you will need to categorize it and make sure you are familiar with trading that specific type as well as measure it. You will also want to measure the gap and ensure that it is at least five times bigger than the usual spread.
On Monday morning do all the above and open a long position if the opening price is lower than what it was on Friday’s close. According to the nature of common gaps, the market will pick up the pace and eventually match the tone of the previous week, making your long position pay off. Pretty much the same logic applies to how to trade gap ups, only reversed.
How to Trade the Gap Up
When you see that the gap on Monday closed higher than opened, it would be a good call to open a short position. As we have already learned from how to trade the morning gap, the market will very likely come back to the previous path and the short position will bring you profits after the gap is filled.
Now, that you know how to find a gap in trading prices and trade it successfully, it is important to mention that gaps are not wildly ordinary and you won’t make a fortune, if you only trade gaps. So, keep looking for other strategies that fit your preference and make sure to seize every possible opportunity by learning to see the big picture of the market.