Keen observers of price behaviour have no doubt discovered that from time to time, gaps appear in the normal price sequencing. These can usually be seen clearest on a technical chart.
Gaps are areas on a chart where the price of a financial instrument has moved either up or down with no trading in between. As a result of this, the chart shows a “gap” in price. Gaps most often appear between the close of a market and the next session’s open. However, they can also – albeit less frequently – appear intra-day. Gaps can occur as a result of a variety of technical and fundamental reasons. For example, a gap on a Daily chart may be seen if a company announces strong earnings after the market close and its stock then gaps up on the open of the next day. An intra-day gap may appear when, for example, the bid/ask spread widens and market participants may need to pay up or down to enter or exit the market causing price to “jump” from the last traded price to the next that the trader can get filled at. This can often be seen around the release of key market news.
Some quick research on gaps shows that there are several different types of gap including breakaway gaps, exhaustion gaps and common gaps. Each one is said to signify a different outcome for price. Today we are focusing on gaps in the FX markets which are, more often than not, common gaps. In Foreign Exchange markets – which trade 24 hours a day, five days a week – you tend to see gaps occur most regularly on the Sunday open when New Zealand enters the markets first. In actual fact, gaps in Foreign Exchange are relatively common – over the last 18 months there has been a gap in the EUR/USD spot price approximately 65% of the time on the Sunday open. It is these daily gaps that we pay most attention to. One reason that gaps are of interest to traders is because of their tendency to fill. That is to say that price will often trade counter to the direction it gapped in and return to the price at which it last closed on the time frame you see the gap occur. In fact, again, over the last 18 months in the EUR/USD 98% of the gaps recorded have filled at some point. This statistic however, masks the fact that traders can suffer unsustainable draw downs when trying to execute gap-fill type trades on this basis.
However, armed with these statistics, we can get a clear idea that a gap is a “potential setup” that a trader can exploit for profit. One way that these gaps can be traded is by waiting for the market to open and then to see if there is any follow-through in the direction that the market gapped in. If the follow-through is insignificant, we can fade the gap – take a position against the direction the price gapped in – by entering at the first significant support or resistance level that the price reaches and hold the position until the price reaches the Sunday close and the gap technically “fills”.
So, gaps are another example of price behaviour that the astute trader should be aware of. A gap can provide a frame of reference for the trader and those who aspire to be profitable will look at what happens after price creates one in order to spot potential patterns that they can profit from. By back testing the phenomenon, traders will likely be able to work out consistent, controlled ways to exploit these for profit.