The Most Powerful and Profitable Forex Strategy: Trading with Gaps

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Gaps are a periodic occurrence in the forex market and a very regular occurrence in the stock market. What are gaps? Gaps occur when there is a space between the:

  1. a) Low price of the active candle and the highest price of the previous candle, or
  2. b) High price of the active candle and the low price of the previous candle.

Gaps are formed because there is no exchange of shares at the price ranges where spaces are found, according to a publication by Edwards and Magee. Gaps are of various types, and an understanding of the different gaps and the situations that produce them will enable the trader to understand how to trade them profitably.

  • Breakaway (or Breakout) Gaps

Breakaway gaps occur at the start of the trend. They can be seen when price action breaks a key boundary or before a major change in the trend occurs. The length of the gap is significant, as it is approximately the same length as the subsequent price move following the gap. As with most patterns, gaps that occur to the upside have to be supported by an increase in buying volume, while the downside versions do not necessarily have to be supported by an increase in selling volume. This is what a breakaway gap looks like:

Breakaway gaps

The best manner of trading breakaway gaps is to wait a short while for the initial fading or profit-taking by the professionals to see if the gap is filled and if not, to enter in the direction of the gap with a stop at the point where the gap would be filled. If the gap is filled immediately, a stop and reverse may be appropriate, because a sudden failure in a gap is often followed by a large move in the opposite direction from the gap direction, similar to a Specialist’s Breakout.

  • Opening Gap

An opening gap is seen when the new candle’s opening price occurs outside of the range formed by the high and low price of the previous day’s candle. An opening gap does not predict what future price direction would be, as prices may or may not continue in the gap’s direction. Filling of the gap is a situation where price action extends into the area covered by the gap, and occurs as a reversal of the gap direction. Fills are more common in upside opening gaps. Failure of a fill to occur within the first 30 minutes of trading is a sign that the price will continue in the gap’s direction.

  • Runaway Gaps (or Measuring Gaps)

Runaway gaps are also known as measuring gaps, and occur in the direction of the current trend. They tend to occur in the middle of a trend, so they can be used to predict the length of price movements after they have appeared. Typically, the length of the trend before the gap is almost the same as the length of the price move after the gap.

Measuring Gaps

Measuring gaps tend to appear in very strong trends which have seen virtually little or no price retracements.

  • Exhaustion Gaps

Exhaustion gaps are gaps that occur towards the end of extended price moves. The name “exhaustion” provides a clue as to what they are. The problem with these gaps is that they resemble the measuring gaps. They can be distinguished by the presence of one important characteristic: the gap ends up being filled. Look at the chart of the runaway gap. You can see that the red support line indicates where price retraced to following the gap; it ended up not filling the gap. Look at what the exhaustion gap looks like:

Exhaustion Gaps

The critical factor is the filling of the gap by a few candles. Once this occurs, you know you are dealing with an exhaustion gap. In a runaway gap, this does not occur.

You will need some sort of confirmation of the price exhaustion before you trade. This is because there are occasions when price may enter a consolidation instead of a straight forward reversal. Exhaustion gaps occur when the height of fear or greed has reached a maximum.

How to Trade the Various Gaps

It must be said that there is really no way to know what a gap will turn out to be when it appears on the charts. Charts typically only appear at the start of a new trading session (or in forex, a new trading week). Therefore, trading the gaps will require patience to watch the behavior of the candles after the gap has formed.

One method of trading gaps (specifically the breakaway gaps) is a method which uses what is known as a pivot. This method was proposed by David Landry in 2003. Using this method, a pivot is identified. This is a possible reversal point used to determine an area of price reversal as well as future support and resistance following the gap formation and subsequent price action. So what constitutes the pivot candle? The pivot low (according to Landry) is the low price of a candle that is flanked on both sides by candles whose low prices are higher than the pivot candle’s low price. When you see this on a breakaway gap, then know that a pivot candle has formed.

The Most Powerful and Profitable Forex Strategy: Trading with Gaps

Ideally, a breakaway gap should form a new high for 20 time periods, and the retracement that forms the pivot low should not lead to a filling of the gap. If the gap is filled, then the breakaway gap is a false one and it is likely that prices will retreat against the direction in which the gap formed. So you should only trade the gap if:

  1. The conditions mentioned above for the pivot are obeyed (i.e. candle flanked by two candles with higher lows).
  2. The retracement price action that forms the pivot does not close the gap, but should be located above the gap’s lower edge.
  3. Gap is not filled.
  4. Gap leads to new high formation.

To trade this, allow the pivot low to form, then place a Buy Stop order above the high of the candle on the right side of the pivot candle, or you can decide to use a Buy Limit to buy off the low of the pivot candle at a future time if price retraces to that point.

Place the stop loss for the trade at just above the gap’s lower edge or just below the low price of the pivot candle. It is safer to use the former option. This protects your capital in case the gap is filled, as the stop loss will close out the position if price moves to fill the gap.

The scenario above is for breakaway gaps that occur to the upside. If the breakaway gap occurs to the downside, you reverse the entire trade setup and entry sequence.

Trading the Opening Gap

A lot of patience is needed here, as you have to do some watching before taking action. One method of trading the opening gap is to determine the highs and lows of the first three 5-minute candles that occur when a gap has formed. If prices break above the highest point of these three candles, (upside opening gap) or breaks below the lowest price point of these candles (downside opening gap), then price action will continue in the direction of the breakout.

Trading the Opening Gap

There are a few traps with the opening gap. Firstly, the breakout tends to reverse (since it relies on a 5-minute time frame which is too volatile). To counter this, allow a pullback first to the broken high/low before entering the trade. You must use a tight stop as well.

You can also have a situation where the price retraces to break the range formed by the 3-bars in a gap-filling mode. If this occurs, then the previous candle’s closing price will be the new target. If prices bounce between the breakout point and the gap filling line, it is an indication that the gap will reverse.

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