Forex Gap Trading Strategy

The Forex market is open 24 hours every day, however, technically the markets are closed on weekends, Saturdays, and Sundays. Retail traders are the only ones who cannot access the FX market on weekends. There is a possibility that huge banks and hedge funds would continue to trade throughout the weekend, and this trading will generate gaps.

Although technical variables like breakouts may play a role, fundamental news during the markets’ closure to retail traders is the most common cause of gaps. As a result, gaps in the currency market are rare during the week but rather common on the weekends.

As trade resumes on Sundays and Mondays, the price will rise to fill the gap. The graphic below illustrates this exact scenario. If the gap was on the upside, the price would likely fall to close the gap.

Large price swings in assets provide chances for traders in volatile markets. Gaps appear on a stock price chart (or the price chart of any other financial instrument) when the price of the stock swings abruptly up or down with little to no trade in between. Therefore, a break in the asset’s regular price pattern may be seen on a price chart.

The savvy trader can identify these gaps and capitalize on them. In this post, we’ll go over the basics of gaps and how you can use gaps to your advantage in the financial market.

What is a Forex Gap?

A “gap” is defined as the absence of trade activity in a certain region of a chart. The market has started at a different price than it closed at the previous day, and this will seem like a sudden, extreme rise or fall in the price of an asset.

A “gap” in the market happens if the starting price is either higher than the high price from the previous session (gapping up) or lower than the low price from the previous session (gapping down) (gapping down). Notice how the previous day’s opening was higher than the previous day’s high. You can see the “gap” between the blue and red horizontal lines.

Forex Gap Trading Strategy
Forex Gap Trading Strategy

Forex traders can profit from gaps since it is generally accepted that gaps are filled rapidly, allowing them to make some pips by accurately predicting the most probable short-term direction of the price. However, if they get the direction of the gap wrong, then losses can be bigger than expected.

Gaps can be classified into four groups:

  • Breakaway gaps: Breakaway gaps emerge at the end of a price pattern and represent the start of a new trend.
  • Exhaustion gaps: Occur at the conclusion of a price pattern and signal the last push to reach new highs or lows.
  • Common gap:  They are just areas where the price has gapped and cannot be placed into any existing price pattern.
  • Continuation gaps: There is a rush of buyers or sellers who all have the same opinion about the future direction of the underlying security when a gap appears in the midst of a price trend.

Forex Gap Trading Strategy

Finding price gaps in currency pairings over the weekend and placing trades based on the expectation that the gap would be filled by Tuesday evening has proven to be a simple trading approach. Only the weekly time frame is needed for trading using this approach but you can really drill down into the price action for deciding which direction to trade on the intraday charts.

Typically, price gaps in the EUR/USD and USD/CHF pairings are rapidly filled. If the price gap between two currency pairs is smaller than 75 pips, traders might expect the gap to close quicker. Predicted fills in the direction of the long-term trend increase the likelihood that a weekend pricing gap will be filled swiftly. However, what has happened in the past is by no means any reflection of what will happen moving forward, so go careful.

Forex traders can take advantage of the gap-closing bias by placing a trade as soon as the gap is formed at the start of the week. Take profit could be set to the range of the previous week, and stop loss should never exceed the number of pips targeted by the take profit level. Personally, I would want to shoot for a favourable risk to reward ratio of at least 1:2 if taking a trade.

One alternate approach into a forex gap trading strategy is to monitor price movement on shorter time frames, and then initiate a trade in the direction of the fill with a tighter stop loss whenever price activity shows a move is likely underway.

What you should keep in mind while trading gaps:

  • Due to the lack of close support or resistance, once a currency begins to fill the gap, it is not always going to reverse course.
  • Remember that the price movement you anticipate depends on the kind of gap you play—exhaustion or continuation.
  • Although retail traders are more likely to display irrational exuberance, institutional investors may join in to try and boost their portfolios; thus, traders should proceed with caution when employing this signal and wait for the price to start breaking before taking a position.
  • Reduce the volume if necessary. Volume increases during breakaway gaps and decreases during exhaustion gaps.
  • Your stop loss or take profit targets might not get executed at the prices you expect if your broker is closed over the weekend.
  • Broker spreads can be very high just before and after weekend gaps, so this can make it difficult to trade the gap successfully.

To bring these concepts together, we will analyze a simple gap trading system designed for the currency market. This system analyses price gaps to try and predict possible price retracements. This is how it works:

Buy Signal

  • Choose a currency pair with a high level of volatility.
  • Check for a gap as the new week begins. A gap must be at least five times larger than the pair’s typical spread. Without it, we can’t even call it a signal.
  • If the market opens on Monday and stays lower than it closed on Friday, that’s a positive gap and we might look to go long (buy).
  • Tight stop-loss levels aren’t ideal for this strategy, and taking profits early isn’t advisable either.
  • Ideally, you’d close the trade within the last few minutes of the weekly trading session.
Forex Gap Trading Buy Signal
Forex Gap Trading Buy Signal

Sell Signal

  • Choose a currency pair with a high level of volatility.
  • Check for a gap as the new week begins. A gap must be at least five times larger than the pair’s typical spread. Without it, we can’t even call it a signal.
  • If the market opens on Monday and stays higher than it closed on Friday, that’s a negative gap and we might look to go short (sell).
  • Tight stop-loss levels aren’t ideal for this strategy, and taking profits early isn’t advisable either.
  • Ideally, you’d close the trade within the last few minutes of the weekly trading session.
Forex Gap Trading Sell Signal
Forex Gap Trading Sell Signal

Forex Gap Trading Pros & Cons

Pros

  • Support and resistance lines may benefit from the added confluence that gaps give.
  • Can catch some big market moves in a few days if you are on the right side of the gap.

Cons

  • The forex gap trading strategy is an extremely high-risk trading strategy.
  • Gaps can go past stop loss levels and cause larger losses than expected if on the wrong side of the gap.
  • Forex brokers usually have very bad trading conditions before the market close and around the open.

Conclusion

When working with currency pairs that exhibit a high degree of volatility, trading the gaps in the forex market can be a lucrative venture, but it is also a very dangerous strategy in my opinion. You should proceed with caution if you want to trade the gaps since there is no assurance that the gaps will be filled and trading conditions around the weekend gap can make things very difficult. Stop losses are recommended for traders who like to limit their losses but there is no guarantee the trade will be closed if your broker is not open. Even if you don’t want to trade the gaps in the forex market, you can still utilize them to find reliable candlestick patterns to trade in the direction you believe the gap may be closing.

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