In the context of the financial markets, a price gap is a discontinuous space on a chart. Gaps are typically formed at the interface between trading sessions.
Today, let’s find out what a gap is and how it’s formed, as well as analyze how to protect ourselves during gaps and take a look at a making-money strategy.
1. Why Do Gaps Form
2. What Causes Gaps
3. How to Protect Oneself from Gaps
4. Can We Use Gaps to Make Money
Why Do Gaps Form
Price gaps are caused by the fact that the supply-demand ratio of an asset changes dramatically when the market is closed, e.g., there can be many people who want to buy rather than those who are ready to sell at the current price.
If we have some counterparties that are willing to sell at a higher price, the market opens with an up gap. In contrast, we get a down gap when there is a large number of sell orders and no buyers at a price that’s almost equal to a closing price of a previous candlestick.
What Causes Gaps
Why do we have such a major imbalance in prices and what is a gap in the Forex market? Most often, price gaps can be observed in the currency market after the weekend.
This occurs if — while the market is closed — we have something that impacts supply or demand:
- political news, e.g., elections;
- important economic decisions being adopted;
- statements from power players;
- force majeure circumstances. For instance, in March 2020, OPEC+ failed to strike a deal about oil production cuts, which led to the fact that trading sessions with a gap were seen not only in terms of oil but also currency pairs involving the Canadian dollar and other commodity currencies.
What is a gap in the context of the stock exchange? The stock markets more often experience gaps due to the long breaks between their sessions. Gaps are typically formed after the quarterly reports are submitted — companies provide a summary of their financial performance preferably before or after a trading session.
How to Protect Oneself from Gaps
Now you know what a gap on a chart is. What are its dangers? It’s all about your losses. Suppose, you have an open trade with a stop-loss order. If a gap occurs at the beginning of a new trading session and your stop-loss order is trapped by a gap, it’ll close at the closest price that appears on your chart. This means that your losses will be greater.
It’s hard to protect oneself from a “gap trap”. However, some measures can help minimize risks:
1. In case of a risk gap, you shouldn’t keep forex trades open for the weekend.
2. It’s harder to avoid gaps in the stock market in the case of long-term or medium-term trading. By not keeping positions open before the quarterly reports are released, you can partly mitigate the risk.
3. Make use of portfolio diversification strategies. In this case, even if you get a gap, the losses resulting from one instrument can be offset by the profits made with other assets.
4. Stick to the risk management rules and don’t skate on the thin ice of the margin call. Manage your trading risks expertly!
Can We Use Gaps to Make Money
We’ve answered a question about what a gap is and also analyzed some safety measures. Can we profit from gaps? In most cases, yes, we can. The money-making strategy based on price gaps relies on a closing gap. According to statistics, about 70% of gaps in the following pairs (EUR/JPY, EUR/USD, GBP/JPY, and GBP/USD) overlap in the exchange market.
When a gap occurs at the opening of a trading week, you can use the following roadmap:
1. Measure your gap. Trade only the one that’s more than 20 pips.
2. Track the situation on a 30M time frame. As soon as the first candlestick has closed, enter a position on the side of a closing gap.
3. Place a take-profit order approximately three pips below the low of the final 30M candlestick on Friday or above the high of the last 30M candlestick on Friday.
4. Calculate your stop-loss order so that it’s one and a half times larger than your take-profit order.
Please keep in mind that not all of the gaps overlap, while those that do so may still close your trades using stop-loss orders. So, make sure to enter a position with a safe volume when using this strategy.