Gap Trading Strategies
Gaps are areas on trading charts where price has moved rapidly upwards or downwards without leaving any discernible evidence. Consequently, gaps are displayed on candlestick charts by a significantly large distance between two consecutive candles, as illustrated in the following diagram.
Types of Gaps
Breakaway Gaps appear towards the end of trends and signal that a major reversal could be imminent. They are usually followed by a series of new lows on a downside breakout (see below diagram) or a series of new highs on an upside breakout. They are not normally closed. An example is shown in the next diagram.
Exhaustion Gaps are generated by the price exerting one last effort to achieve a lower low or a higher high when a trend starts to peter out. They are closed shortly afterwards. The following diagram shows an example of an exhaustion gap.
Common Gaps can be created at any time and are not identified with any price action. These gaps occur when there is no strong trend. Common gaps are closed quickly as shown in the next diagram.
‘The gap is filled’ is an important expression that is applicable when price progresses back to the value it had before the gap was generated. Such events occur relatively frequently resulting from over-enthusiastic trading creating price surges that then need correcting. Successful traders have developed a number of Forex trading strategies to help them profit from gaps, such as the following.
Tracking global news during the weekend can be a profitable venture if you can first identify any major trading discontinuities associated with this activity. If successful, then attempt to deduce the causes for such actions. If Forex then commences the new trading week revealing a gap, you will then be well-positioned to initiate a new position to trade this event. Once price starts to fill a gap, this process rarely ceases because there does not exist any intervening resistances and supports capable of stopping it.
The next gap trading strategy has been developed to predict price retracements and consists of the following rules. A new position must only be open in the current direction of the prevailing trend. Price must then jump in value forming a gap above resistance or below support before returning to its initial resistance level. Such a process would fill the gap. The following diagram shows such a trading setup.
You must then pause until you can visually detect a candlestick verifying that price is now progressing in the initial gap direction. This technique ensures that the original resistance, which is now the new support, has held. This strategy also presents excellent entry points for new positions possessing optimum reward-to-risk ratios. You should place your stop-loss about 50 pips beneath the new support line as shown in the above diagram.
When to trade gaps
Gap trading is not new and has been used to trade the stock market and commodities for a long time. This strategy is not often utilized by Forex traders. This is because gaps depend basically on the stock markets shutting down for a period of time, such as overnight. However, as Forex does not close except over the weekend, the formation of gaps is much rarer events. In fact, there is only one time when a gap trading strategy is possible, which is when Forex re-opens late Sunday afternoon.
Although this presents minimum opportunities to trade gaps, Forex gap strategies possess high success rates in the region 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.
1. The price can open above Friday’s close called “gapping up”.
2. The price can open below Friday’s close called “gapping down”.
3. The price can open at the exact same price as Friday’s close meaning that no gap has been generated.
The primary rule to trading gaps is fundamental. Whichever direction in which the gap is expanding, you instigate a trade in the opposite direction. You will be amazed just how often this straightforward strategy succeeds and that it could supply you with the basis on which you can successfully construct your Forex career.