Gap trading – how to do it

Often in trading, a “gap” is a scary, mysterious chasm, into which our profits can disappear.

Perhaps we’re waiting for our trade to trigger, when the market gaps up, and our order fills at a much higher price than we’d wanted – a healthy chunk of our profits eaten up …

Or we’re already in a trade, and the market gaps down through our stop level, closing us out beyond where our stop loss should have cut in – leaving us with a nasty loss that was significantly higher than we’d expected.

So, what goes on during these voids on our charts?

Usually, an event may have had so much impact that investors suddenly have a different expectation of value, causing a “jump” in bid/ask rates.

One of the most common places for a gap is over a weekend, when markets are closed, but, of course, the world keeps turning on its axis, with financial and economic events still taking place.

As traders, there are two things we need to learn about gaps …

The first is how to avoid falling into them …

And the second is to turn them into profits …

Gap trading: how to negotiate gaps

No one can accurately predict when a gap will occur, but we can have an idea of when they are more likely to happen.

The first precaution we can take it to watch out for economic announcements – I’m talking about stuff like non-farm payrolls … interest rate statements from the Bank of England, the Fed or the ECB … and G7 financial meetings (especially over a weekend) …

All these are events when markets can sudden make big moves.

Non-farm payrolls happen (usually) on the first Friday of each month, and the day’s trading is characterized by very quiet, flat markets in the lead-up to the announcement, followed by sudden swings up or down (or often both) immediately before and after the news.

The second precaution that a short-term trader can take is to close positions over a weekend. This way you’ll avoid extra financing charges, and the risk of a sudden gap as the markets reopen on Sunday evening.

Finally, if you’re a scalper, using relatively high stakes while looking for just a few pips in movement – you are more at risk of gaps than a trader with lower stakes who’s holding positions for longer. Always bear this in mind when considering how much time you leave positions open for, and when economic news is due out.

Filling a gap

So, that’s the bad news about gaps.

But traders are a resourceful bunch of people, and have quickly spotted that gaps in the market can sometimes leave us with a good gap trading opportunity.

You may have heard the saying that “the market hates a vacuum” or “filling a gap” or, as the Japanese put it – “closing a window”.

What all these euphemisms are saying is that there is an expectation after a gap in the market that the price will come back and “fill” that area of white space on the chart.

Something like this …

Here we see the price gap suddenly down, retracing to “fill” that gap, before continuing its downward trend.

So, if we see a gap, all we need to do is set up a trade to “fill” that gap, right?

Well, no.

Unfortunately, it’s not that simple.

The problem is that the presence of a gap indicates momentum in the market, and it can be dangerous to stand in the way of that momentum. Sure, often a price will retrace and “fill” a gap – but sometimes that will take days, weeks or months.

Meanwhile, the market can be tearing off in the wrong direction with great enthusiasm!

So, is there a way to safely profit from market gaps?

Know your gaps

The first thing to understand is that there are different types of gap, and some of these gaps are less likely to fill than others.

The types of gaps that any “gap trader” should be wary of are called “breakaway gaps” and “runaway gaps”.

These are gaps that form part of a trend that has some momentum.

In this example we have a breakaway gap, where a trend takes off after a period of consolidation.

Here the price has considerable downside momentum, and shows little interest in retracing to “fill the gap”.

Another type of gap that forms within a trend is called an “exhaustion gap”. These occur near the end of a trend, when the last flurry of buyers or sellers jump on board. This is a gap type that’s likely to be filled, as the market runs out of steam, but is notoriously difficult to spot.

The final type of gap simply covers anything that doesn’t fit into any of the other categories – it’s usually referred to as a “common gap”. And it’s the common gap that gap traders are looking out for.

Successful gap trading

The idea that gaps will be filled is a very compelling one for traders who are interested in price action, but I strongly advise caution. Holding positions while you wait for breakout and runaway gaps to be filled can have a devastating effect on your trading fund – when, in fact, trading with the trend would have enabled you to profit from a big move.

Gap trading can be a great profit tool, and I’m currently testing out some strategies that would allow you apply them safely, and profitably. There’ll be more on this in the future …

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