Forex Gaps Strategy

Unlike with the stock market, where gaps occur on a daily basis, the Forex market trades 24 hours a day for 5 days of the week.  The weekend break leaves an opportunity for prices to move while the market is closed, and causes a gap window opening on Monday morning.

On the stock market, gaps occur because some of the most important news breaks when the market is closed. When we’re trading forex gaps we really don’t care about what gap was caused or by whom, because when you trade gaps successfully, you’re just using technical analysis of the trends and you don’t really need to be read up on the news.

What is a Gap?

A gap is when a currency pair opens the day (or any other time unit measurement) above or below the previous trading day closing price. Usually in the Forex market, gaps happen over the weekend, at the opening price of the new trading week when the price opens significantly higher or lower than Friday’s closing price. However, gaps can also form intraday during high-impact economic news releases because the liquidity will dry out and cause big gaps in price.

Figure 1: Gap Up

Figure 1: Gap Up

Not every gap has the same price structure as they come in different shapes, some being larger than the others and the reason for the gaps is not always the same. Profit can be made by trading on the opposite side of the gap, as the gap is filled, as well as in the direction of the gap. Going forward, we’re going to look through the 4 main types of gaps that exist.

Figure 2: Gap Down

Figure 2: Gap Down

Type of Gaps

  • Common Gaps: As the name suggests, they occur very frequently. A common gap basically has no real fundamental reason for existing as a catalyst on the market.  It is s more just a psychological effect that happens when the market consolidates. Most common gaps are filled the same day they are made.

common-gap

  • Breakaway Gaps: Not as frequently in market activity as the common gap, a breakaway gap is not likely to get filled in the short-term, however, there are some partial fills. At first, a breakaway gap has a consolidation period, where price activity stays within a trading range where the buyers and the sellers agree on the “fair value” price. The breakaway from this trading range can happen with the price gapping above/below the range.  This can be due to either some news events or because of the supply-demand imbalances. Most of the time the Breakaway gaps occur at the beginning of a new trend.

breakaway-gap

  • Runaway Gaps: The Runaway Gaps are also known as the Continuation Gaps because they don’t get filled and the market tends to trade in the direction of the gap. Runaway Gaps happen during a strong trend and occur in the middle of the trend as its shows a high level of interest from market participants. The Runaway Gaps also work as great support and resistance levels in the direction of the prevailing trend.

runaway-gap

  • Exhaustion Gaps: The Exhaustion Gaps are a great reversal signal as they happen at the end of a trend. Exhaustion Gaps happen due to a trader’s fear of missing the trend. The traders and investors who missed the trend (usually are referred to as “late to the party”) find it difficult as a strong trend will not give you many opportunities to break in. As the trend develops, everyone who missed the start of the trend will jump in – creating a buying/selling hysteria right at the top/bottom which exhausts the price – hence the name Exhaustion Gaps.

exhaustion-gap

Important Notes When Trading Gaps

Now that we have learned the different types of gaps it’s important to keep in mind that not every gap is tradable. 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, we should only look to trade gaps that are at least in 40-50 pips range.

Another important note – time matters. 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’ll understand them better, and you will be able to frame your own strategies on gap trading.