Forex gap trading can be a profitable trading strategy, if you know what you are doing. In this post, I will explore the definition of a gap and hopefully get you to increase your awareness of them.
The purpose of this post is not to teach you one way to trade it and say that is the only way. I'm going to show you several different methods and allow you to choose the one that works best for you.
I will also show you how to test these different strategies, without risking any real money. Gap trading can be an effective trading strategy that you can add to your arsenal. They are easy to spot and can be traded with a rule based system.
I'm going to skip the normal, definitions that you can read on any other website. Hopefully these definitions are more practical. They are the way that I like to think of them.
The Real Trading Gap
The obvious type of gap is well, an actual gap in price. You will typically see this when the market opens on Sunday, after there has been some big news over the weekend.
For example, this is the EURUSD chart recently. This was what the price action looked like when the situation in Greece was still up in the air.
As you can see the gaps were fairly significant. If you were in a long trade over the weekend, you could have lost money when the markets opened on Sunday.
Why Gaps Happen
We see gaps when surprise news comes out, or if there is a lot of economic activity over the weekend. Traders want to capitalize on the events and suddenly move the market in one direction.
Forex Gap Trading
These are some of the ways that you can choose to trade a gap. There are other ways to do it, but these are the most commonly taught methods.
Gap Fill
The most common way to trade a gap is to assume that it will get filled at some point. In other words, you would enter the trade when the gap appears and target some point inside the gap.
Some traders target half the gap, just to be safe, while others target the whole gap. The method you choose will depend on the pair you are trading and what your testing has told you works the best.
Where to set the stop loss isn't as clear and will take some testing and experimentation. You could set it at a previous level of support/resistance or you can set it at an acceptable R multiple of your profit target.
For example, let's say that you always target 50% of the gap and you want a minimum 2R. So if your target is 100 pips away from your entry, you would set your stop loss at 50 pips.
A gap tends to get filled because the market wants to bring price back into balance after such a large imbalance. When the gap doesn't get filled right away, or it doesn't get filled completely, you could have a major followthrough on your hands.
Followthrough Gap
Another way to trade a gap is to trade the price action after the gap is filled. Some traders assume that it will act as an area of support or resistance and that price will continue to move in the direction of the gap.
So you would wait for the gap to be filled, before entering the trade. In this example, it worked out well and price rocketed back up, after the gap was filled.
To trade this method, you would have to judge the strength of the trend and make a call on a continuation.
The Pseudo Trading Gap
There is another type of trading “gap” that doesn't get mentioned too much, but it is a pattern that you should still look out for. Instead of a physical gap, price simply moves very quickly through a price range. This is a concept that I learned from Chris Lori.
Since there is actually price action through this price range, I consider it a Pseudo Gap. Whenever price returns to this area on the chart, it can have the tendency to run through that price range very quickly.
As you can see here, after the real gap was filled, price continued upwards to form a Pseudo Gap (shown by the arrow). Then when price returned downwards, that area on the chart was filled quickly.
So just like a Real Gap, this gap also has the tendency to get filled. Since the price action associated with this type of gap is less sudden, the fill should also have less force.
Therefore, if you do take these types of trades, it is better to target fewer pips than with a Real Gap. Again, test it out and see what works best for you.
Conclusion
At the end of the day, it is up to you to decide on the gap trading method is best for you. The only way to figure it out is to learn different systems, back/forward test them and figure out which one you resonate with.
Finally, remember that we don't trade in a vacuum. Always take into account current economic and geopolitical conditions, as well as upcoming news announcements.
To learn more about gap trading strategies, you can do a lot Googling, or you can simply take a course from one of the price action traders on my list. Once you learn a method to test, be sure to fire up Forex Tester 2 and a demo account to test it extensively before you ever put real money on the line.
Several traders that I have talked to trade gaps quite successfully, so it is certainly worth the time to try to figure them out and work them into your trading quiver.
If you currently trade gaps, what is your best strategy?
Disclosure: Some of the links on this page are affiliate links.
Good Stuff Hugh! I never heard of that second type of gap but it makes sense. Chris Lori definitely knows what he is talking about. Thanks!
You’re welcome, glad you liked it.