When it comes to trading, understanding gaps is pivotal for traders aiming to navigate and capitalise on market volatility. These spaces on price charts where no trading occurs are often exploited by traders looking for a quick reversal or trend continuation. This article delves into the essence of gaps, their types, and three gap trading strategies.

Understanding Gaps in Trading

Understanding gaps in trading is crucial for both new and advanced traders, as these occurrences can signal significant price movements and opportunities. A gap is observed on a price chart when the price of an asset sharply moves up or down with no trading in between, creating a visible space or 'gap' in the price pattern. They almost always happen at the market open but can also occur after major news events or economic announcements, reflecting a sudden change in sentiment.

There are four main types of gaps, each offering different insights and implications for traders:

• Exhaustion

These appear at the end of a price movement and signal that a trend may be running out of momentum, potentially leading to a reversal. This type is characterised by a sudden move in the price in the direction of the prevailing trend, but with the trend quickly losing strength and often reversing after the gap is made.

• Breakaway

Occurring after a period of consolidation, breakaway gaps signify the start of a new trend. They emerge when the price moves away from a trading range or pattern, indicating a significant change in market dynamics and the potential for a sustained move in the direction of the price jump.

• Continuation

These gaps are seen within a strong trend and signal that the current trend is likely to continue. Continuation gaps represent a surge in interest in the direction of the prevailing trend, reinforcing the current momentum and suggesting further movement in the same direction.

• Common

These are the least significant and occur frequently without implying any particular price direction. Common gaps are typically filled quickly and can be a result of minor fluctuations that temporarily create a small jump in the price pattern.

The Significance of Gaps in Forex and Cryptocurrency Markets

In the world of trading, the occurrence of gaps on price charts holds particular significance, offering insights into market sentiment and potential shifts in price dynamics. This is especially true in the forex and cryptocurrency markets, where they convey unique implications due to the nature of these markets.

In forex, gaps are relatively rare compared to stock markets, primarily because forex is traded 24 hours a day, five days a week. However, this unique feature is what makes the gaps important for identifying price movements. Usually, they occur at the beginning of the trading week or after major geopolitical events and economic announcements that happen over the weekend. They’re closely watched by traders as they can indicate a strong initial reaction to news or events, potentially setting the tone for trading in the coming days.

Cryptocurrencies, traded continuously 24/7, experience gaps even less frequently than forex. The non-stop nature of this market means that price action is constant, leaving little room for price jumps to form on price charts. However, when they do appear in cryptocurrency markets, often on derivatives charts rather than spot, it can signal extremely impactful events or significant shifts in trader sentiment. Given their rarity, gaps in cryptocurrencies are particularly noteworthy and can represent critical trading opportunities or warnings for investors.

In both scenarios, the gap is likely to be filled at some point. Often, this occurs on the same day or within a few days of its appearance. However, a gap can remain unfilled for several weeks or months, depending on the market context. It’s worth determining the type of gap you’re looking at to gauge whether the price will reverse quickly or kickstart a new trend.

Three Gap Trading Strategies

Now, let’s take a closer look at three gap trading strategies that can be used in the forex and crypto markets. Want to follow along? Using FXOpen’s free TickTrader platform offers access to live forex and crypto CFD charts.

Gap and Go Trading Strategy

The Gap and Go trading strategy is a popular gap trading technique that emphasises the power of momentum following a sudden market jump.

This approach is particularly effective in capturing the initial movement after a gap appears, usually at the opening of the trading week in forex. The strategy focuses on identifying strong momentum indicated by breakaway or continuation gaps on daily or weekly charts. However, it can also serve as a valuable tool for setting short-term direction on lower timeframes.

By aligning trades with this initial burst of momentum, traders can potentially capitalise on swift movements before the price settles.

Entry

• Traders typically look for a jump that occurs in the direction of the prevailing trend.
• Entry is often considered as soon as the candle opens after the gap.

Stop Loss

• Stop losses are commonly placed just above (for short positions) or below (for long positions) the high or low of the previous candle's trading range.

Take Profit

• Profit targets might be set at a nearby support (for short positions) or resistance level (for long positions) on the same timeframe as the entry, allowing traders to lock in returns before the market potentially reverses or consolidates.

Quick Reversal Gap Trading Strategy

This strategy focuses on exploiting the tendency of gaps that go against an established trend to get filled quickly. They are typically interpreted as common gaps, which arise due to an overstated response to overnight news or weekend events.

Unlike exhaustion gaps that signal the start of a new trend, this type usually represents temporary deviations from a prevailing trend, leading to quick reversals as the market reassesses and corrects the initial knee-jerk reaction. This filling process is attributed to the market's natural inclination to maintain a trend unless given a strong reason to reverse.

Entry

• Traders identify an existing trend using a daily or weekly chart.
• For a bullish trend, the strategy involves looking for a candle opening price that is lower than the previous close (and the opposite for a bearish trend).
• The entry point may be set when this counter-trend gap is identified.

Stop Loss

• A stop loss may be placed just beyond a nearby swing point.

Take Profit

• Profit targets may be established at the close of the candle before the gap, where the jump is expected to be filled.

Small Gap Fill Trading Strategy

When trading gaps in forex, it’s common to see small gaps being filled within a short period, often within a day or two. This strategy is tailored to identify spaces that are relatively minor, typically less than half of the previous day's trading range.

While strategies that align with momentum and trends may have a higher probability of an effective trade, the market's inherent desire to seek equilibrium makes even small, seemingly insignificant gaps likely to be filled.

Entry

• Traders look for a small price jump, ideally less than half the size of the prior day’s range, entering in the direction anticipated to fill the gap.

Stop Loss

• A stop loss may be placed slightly above (for short positions) or below (for long positions) the day's open, allowing for some intraday price movement.

Take Profit

• Profits may be taken as soon as the close of the candle preceding the gap is met, capitalising on the quick return to balance.

While this strategy may carry higher risk due to its simplicity and lack of supporting factors (like trend analysis), its effectiveness can potentially be enhanced by using other forms of analysis. For instance, if the gap occurs near a support or resistance level, the likelihood of the gap filling may increase.

The Bottom Line

Understanding and trading gaps in the forex and cryptocurrency markets may offer unique opportunities for informed traders. However, it may be worth combining these strategies with a solid understanding of market conditions and technical analysis to enhance their effectiveness.

For those looking to apply these strategies and more, opening an FXOpen account could be the next step towards engaging with forex and cryptocurrency markets via CFDs.

FAQs

What Is a Gap in Trading?

A gap in trading refers to a significant price movement on a chart where no trading occurs, leaving an empty space between two trading periods. This jump, either up or down, is often influenced by news events or market announcements.

How to Predict a Gap Up or Gap Down?

Predicting a gap up or down involves analysing market sentiment, news events, and technical indicators that might influence the opening price of an asset, usually over a weekend or when the market is closed. Traders closely watch for indicators of sudden shifts in demand or supply that could lead to a price jump.

What Is the Forex Gap Strategy?

The forex gap strategy leverages markets' tendency to fill gaps after they occur. Traders identify potential price jumps over the weekend or after major news releases and position themselves to capitalise on the price movement back to the pre-gap level.

How to Trade Gaps?

Trading gaps involves identifying the type of gap and employing a strategy suited to its characteristics. Traders might enter trades in the direction of the gap's fill or anticipate a continuation of the trend that caused the jump.

What Are the Four Types of Gaps in Trading?

The four types of gaps in trading are Breakaway, Exhaustion, Continuation, and Common. Each type indicates different market conditions and potential future price movements, guiding traders on how to position their trades.

At FXOpen UK and FXOpen AU, Cryptocurrency CFDs are only available for trading by those clients categorised as Professional clients under FCA Rules and Professional clients under ASIC Rules, respectively. They are not available for trading by Retail clients.

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