The forex market is closed from Friday evening until Sunday evening. Quite often the price that currency pairs open at on Sunday is different from what they closed at on Friday – this difference is called a ‘Gap’. Gaps in forex trading refers to the spaces on the chart where prices move sharply which resulted in almost zero trading between previous price to the next price. In the beginning of the week, prices could jump up or down compared to the last price before market closed in the week before. Gaps can also happen in the middle of the week after highly influential news release or market panics due to unexpected occurrence.
If last week market was falling then more or less price might gap down when market first open on Monday morning. The opposite is true if market sentiments was bullish prior to Monday morning. Technically speaking if gaps occur in any pair in the forex markets it occurs when price move sharply up or down where there isn’t any trade to begin with. Many institutional traders took this opportunity to make a good profits.
Certain clues can lead a trader to know when a weekend gap will occur. When there is a major political or economic event that will affect the demand on a currency or an asset, this will likely produce a weekend gap. As a trader, the weekend gap can make you some good money if you know how to play it. It is virtually impossible to predict the direction the weekend gap will take. Obviously if you are in a currency position at the close of the market on Friday and the market gaps in your favor, you are in for some good money. But if the market gaps against you, you stand a chance of not just losing the trade, but losing more than your stop loss target as a slippage could occur, pushing you deep into red territory.
A strategy that actually works is not about trading the gap itself, but trading the gap closure. The gap closure is a phenomenon that occurs when the market realizes that the reason for the gap was actually not so wonderful as to sustain the trade in the direction of the gap. As such, we will see traders unwinding gap positions and trading against the gap. The traders’ experience has shown that in more than 70% of cases the gap actually closes. So the advice on trading the gap here is to wait for the market to open, and immediately trade against the gap using sound money management.
Gap trading is nothing new. It is been used in the stock market and in commodities trading for decades, and takes advantage of the difference, or "gap" between the closing price of the day before with the opening price of the next day. Gaps rely on a market close, and since the forex market never closes, it's really hard to get a gap or take advantage of it. In fact, during an entire trading week, there is only one time when using gap trading strategies in the forex market is even possible! Sunday night at the open is the only time that gap trading forex is possible.
Types of Forex Gaps
The market is range bound and gaps away from this range signaling the potential of the start of a trend. Breakaway gaps appear when the price breaks from a price pattern or above/under important levels and shows that the market is ready to continue the move and they are not that easy to be covered. A Breakaway gap takes place at a key level of price support or ceiling. The significance in a breakaway gap is that everyone holding back price at a certain level has obviously rushed out of the trade in such a way that the current trend may likely resume with little push back. A breakaway gap is similar to a seismic shift that can alter the likely route of price action for a significant amount of time to come.
Continuation gaps occur in the middle of a price pattern and signal a rush of buyers or sellers who share a common belief in the underlying stock's future direction. This gap known as a continuation gap is often seen alongside trend lines. If you’re holding a trade in the direction of the trend and find yourself in the favorable position of being in the trade that just gapped in your favor you may want to tighten your stop as the trend is likely confirmed and those who may have been on the other side of your trade are likely less of a force as their mass exodus caused the gap.
Exhaustion gaps occur near the end of a price pattern and signal a final attempt to hit new highs or lows. An exhaustion gap often happens when markets are parabolic or trading in a straight line and the last of the trend followers have entered into the trade. Naturally, when you have no more people entering into the trade the price will often fall and fall fast and the trend has likely ended. An exhaustion can often follow the previously mentioned type of gaps and can be used as a great entry confirmation of a trend turn.
When gaps are filled within the same trading day on which they occur, this is referred to as fading. For example, let's say a company announces great earnings per share for this quarter, and it gaps up at open (meaning it opened significantly higher than its previous close). Now let's say that, as the day progresses, people realize that the cash flow statement shows some weaknesses, so they start selling. Eventually the price hits yesterday's close, and the gap is filled. Many day traders use this strategy during earnings season or at other times when irrational exuberance is at a high.
Those who study the underlying factors behind a gap and correctly identify its type can often trade with a high probability of success. However, there is always a risk that a trade can go bad. You can avoid this by doing the following:
- Watching the real-time electronic communication network (ECN) and volume: This will give you an idea of where different open trades stand.
- Being sure that the rally is over: Irrational exuberance is not necessarily immediately corrected by the market.
- Using a stop-loss: Always be sure to use a stop-loss when trading. It is best to place the stop-loss point below key support levels, or at a set percentage.