A Few Words About Gaps
A gap is formed when the latest quotes on Friday are significantly different from the open price next Monday. The chart immediately forms a gap and you can’t confuse it with anything. If the two nearest candles are at a great distance from each other, then you are looking at a gap. The reason for the gap is the huge number of accumulated orders. At the time of the market opening on Monday, all positions left for the weekend are executed at once and the price jumps.
Gaps are not formed every week. On average, gaps appear approximately once a month on each trading instrument. This occurs when the amount of buy orders significantly exceeds the sell orders and vice versa.
Useful Property of Gaps
The opportunity to earn on gaps exists due to the desire of these gaps to close. That is, if the price jumped to the upside, then with a high probability it will turn around and go down to close that jump. The process works the same way in the opposite direction.
Such market behavior is fairly easy to explain. A sharp change in price on Monday activates a lot of pending orders. Stop Loss levels of these orders are usually set around Friday’s close price. Knowing this, experienced market participants are trying to activate these levels and make some money.
If you ask about further price movement, I should say that you can’t predict its action after the gap is closed. The price behaves unpredictably. Therefore, it is important to use your chance and make profits on price reversal after the gap.
Remember, however, that the gaps are not closed in 100% of cases. Sometimes the market continues to move in the direction of the gap. Most often this is caused by some fundamental events or in the case of a strong trend.
Gap Trading Strategy
The percentage of gap closure varies depending on a trading instrument. The highest percentage is in the following 4 currency pairs:
- EURUSD - around 66%
- EURJPY - around 70-71%
- GBPUSD - around 70-71%
- GBPJPY - around 70-71%
If you want to make money on a gap, open the charts for all 4 pairs. This way you increase your chances to find a gap that will most likely close.
You can use any timeframe convenient you prefer. However, due to the fact that you enter the trade half an hour after the market opens, I advise you to use the M30 chart. Each candle there will show exactly 30 minutes.
Your actions are pretty simple:
- Find a gap on the chart.
- Check the size of the gap. It should exceed 20 points, otherwise, the chance of the gap closing is too low.
- Wait for the close of the first 30-minute candle. According to statistics, the gap will not start to close before that.
- If the gap was moving to the upside, then we are looking for a sell entry point. If the price jumped down - look for a buy trade.
- Set the Take Profit level. For an upward gap, set the level just above the high of last Friday’s candle at M30. For the downward gap set the level 3-4 points below the low level of that last candle. You shouldn't be guided by the closing price on Friday, as the gap seeks to close but not exactly at the closure level. Relying on the high or low of the candle we give ourselves room for maneuver.
- Set the Stop Loss level. It is very important to correctly calculate the level since before the gap closes, the market can fluctuate greatly and go in the direction you don’t need. It usually happens as the experienced market participants try to knock out traders who make a profit on gaps. The ideal distance to Stop Loss would be the distance to Take Profit times 1.5 plus a couple more points. If you take the coefficient higher or lower, then you risk suffering losses or your position will be closed by Stop Loss too early.
When You Shouldn’t Enter the Trade
In addition to the minimum gap size of 20 points, you should pay attention to the distance between the first M30 candle on Monday and your potential target. It happens that the first candlestick on Monday moves towards the gap. The distance to the potential Take Profit is sharply reduced and in this case, it is not worth entering the trade. Make sure your potential profit is at least 20 points away. Otherwise, the potential income will not be worth the risks involved.
Gap Trading Drawbacks
- 29-34% chance that the gap will not close. However, the chance of a successful outcome of 66-71% is quite high. We can say that it is worth trying.
- Gaps are pretty rare. Even taking into account all 4 trading instruments, you will open about 5 transactions per month. If you want to take advantage of trading on gaps, then use it as an addition to your basic strategy.
- Most gaps close within a few hours. Some, however, might take up to 24 hours. If you are a day trader, this might mean that you will have to close your position before you get all potential profits.
The strategy is quite simple and has a high chance of success. Just follow the plan and some of your trading weeks will begin with additional profit.