Gap trading involves making use of those periods where the price moves, often quite sharply, with no or very few trades taking place in the meantime. A gap can be represented or identified on a chart as a price area over which the price action has jumped with no trades taking place in the price area. Prices in a gap period can move both up or down.
Gaps typically occur in the trading break for a particular market. If you were trading on the US session, for example, the Forex market closes at 5 pm on the Friday afternoon in US Eastern time. 17.00 EST equals 22.00 GMT so that’s 10 pm at night in the UK. Important news items are often released by finance ministers, central banks and the like after close of play, either on the Friday evening or the Saturday. This means that prices are apt to fluctuate but with little in the way of actual trading going on. Gaps do not always occur during a market’s weekend break, however. The fact that the market has longer to react to fundamental news over the weekend does tend to make it the most prominent gap but gaps can also occur during overnight breaks and at other times when trading slows.
Gaps can be broken down further into four basic groups. Breakaway gaps occur at the end of a price pattern and signal the beginning of a new trend. Exhaustion gaps appear near the end of a price pattern, signalling a final attempt to hit new highs or lows.
Continuation gaps appear in the middle of a price pattern and tend to signal a rush of traders united in a common belief in the currency pair’s future direction, which could be either up or down. A common gap, meanwhile, is one that cannot be placed within a price pattern. This means that it represents an area where the price has gapped without being part of a readable pattern.
There are several different ways to trade gaps. Some traders will place an order when they believe the news being released after hours will lead to a gap. They might also buy into highly liquid positions at the beginning of a price movement, hoping to see a fill and a continuing trend. A fill is what occurs when the price moves back to the level it was at before the gap appeared. Filling gaps within the same trading day on which they occur is known as fading. Some traders will fade gaps in the opposite direction once a high or low price has been reached.
It can be difficult for new Forex traders to even spot a gap when a new week’s trading opens up. A good tip is to look for a spread that’s at least 5 times the average for the pair. Gap trading can be difficult but with experience and a little experimentation it can be a useful way to boost your winning trades.