How to trade and manage Gaps?

How to Trade the Gaps

What is gap trading?

Some Forex currency pairs move over the weekend between the retail broker closing on Friday (typically 5pm New York Time) and opening on Sunday (also, typically 5pm New York time.) So when the market begins trading again, there is a “gap” between the Friday’s candle and Sunday’s candle. The Forex mantra governing the trade is “the market hates a vacuum”, meaning that the gap between Friday’s close and Sunday’s open must be filled. Taking a position with the “gap fill” in mind, is what we call Gap Trading.

Why are there gaps over the weekend?

Even though the retail traders’ brokers close for the weekend, the banks and large hedge funds still buy and sell currencies all weekend long. Since there is very little liquidity in the market on the weekend (not many trades/traders), the commercial traders often move the market quite a bit, causing the opening price for the retail traders to be different than the Friday closing price. This can be as little as a few pips of movement to as much as several hundred pips. The biggest gaps typically occur on the heels of major news or other events where traders pull money/positions out of the market as quickly as possible fearing disaster and the open price is adjusting to those huge changes in order and volume. In gap trading, we attempt to take advantage of these gap opportunities.

How does gap trading work?

The idea is very simple. We’re looking for the market to fill the gaps and try to get in a timely position to ride the price action back up to prior close.

How to Trade Them?

To start with, it’s very nice to have a “heads up” on which pairs we can expect to see a gap before the broker opens up on Sunday. After an exhaustive search, I discovered NetDania offers forex pricing that moves all weekend long:

You can see in the image that I selected several pairs that showed gaps from Friday’s closing price at my broker.

These are the pairs I chose to track. Since I was trading common currencies between the pairs (i.e. 2 EUR, 2 GBP, 3 JPY, 2 USD), I chose to make my trading size small to reduce my risk. I use multiple pairs in an attempt to increase the probability of hitting my target.

The first chart shows the GBP/JPY when my broker first opened. The clock in the upper right corner of the image shows US Central Time (Chicago Time) which is one hour later than US Eastern Time (NY Time.) Note the opening gap of about 68 pips.

 This chart shows the GBP/USD at open. Opening gap of about 23 pips.

 EUR/JPY at open. Opening gap of about 51 pips.

AUD/JPY at open. Opening gap of about 22 pips.

 EUR/USD at open. Opening gap of about 11 pips. Depending on your spread, this gap may not be large enough to make a decent profit. As you can see the gap was half filled before I even got around to capturing the image. I didn’t actually trade this pair, but I’ve included it for reference.

How do I manage the gap trade?

Sometimes, these gaps go straight to the close; but not always. When you size your position, be sure to allow enough margin for them to swing in the opposite direction a bit. I usually allow them to swing as far against me as the gap is wide. In other words, with a 50 pip gap, I will usually allow the trade to swing 50 pips negative. In fact, I may size my trades in such a way that I can add a position at that point in the same direction to increase the profitability of the trade. If you prefer, you can close your original position for a loss and add a new position.

 Once you get comfortable trading these gaps and understanding their behavior, you can maximize the approach by using key Support and Resistance zones to add to positions and look for high probability bounce spots.

Another tactic I like to use for larger gaps (over 25 or so pips), is to open two half-size positions upon entry and close one for profit when one-half of the gap is filled to lock in profit. 

Then I try to let the second position run all the way to the prior close for max profit.

The point of this article is less to give you a step by step strategy as it’s pretty wide-open in terms of how you can utilize gaps, and more to let you know it is an opportunity that can be explored, tested and leveraged.

http://www.learntotradeforprofit.com/how-to-trade-gaps/