Forex Market Gaps: A Practical Understanding

There are many advantages to trading the Global Forex Markets, hence its growing worldwide popularity and vast number or speculative participants. There are very low startup costs involved with Forex trading, meaning new traders are not forced to commit large sums of capital to an account in the early stages of their career, plus they can also enjoy different levels of leverage as well. As a full-time trader, I work with a variety of products, including Futures, for my intraday activities and mainly Forex spot for my swing and overnight positions. I firmly believe that if one has the right education from the start, then the Forex market is pretty much the safest arena for longer term trades. This is because it is a continuous market from its open on Sunday through to its close for the weekend on the following Friday. This means that there is no danger of gaps between the open and closing prices for the majority of the week, meaning that a trader can sleep soundly at night knowing that he or she is safe in the knowledge that their stop loss order will only be triggered at or very near to the price they originally specified, unlike the stock market trader who is constantly faced with the prospect of a gap up or down after trading closes for the day.

You see a gap up or down in price on the open of the next day of trading can be a highly damaging scenario for the equities trader, as it means that stop loss orders will be heavily slipped should price gap against the position. Let's say, for example, that I bought some shares at a price of $25.35 and placed my stop loss order to protect me in the event of being wrong on the trade at a price of $25.20. With this in mind, should the market go against me and hit my stop loss order, I would only be left with a contained 15 cent loss. However, let's say that after buying the stock it actually went in my favor and closed at the end of the day at a price $25.55 and I decided to hold overnight. Now I would be feeling pretty confident about the trade at this point because I would be ending the day with a current profit of 20 cents, but overnight there was a huge product recall reported on the company and the next day the stock gaps down at the open to $24.80. I would be taken out of the trade for a loss, but not at 15 cents, but instead it would be for a much larger 40 cents! Price would have gapped right over my original stop loss and I would be filled at the next best available price! Not a great way to start the day at all, but this is a common event which all swing traders of the equity markets have to be aware of and prepare for each and every time. Due to the 24-hour nature of the Forex market, we are only at a potential risk of a gap once per week, at the open on a Sunday, making this a far more attractive market to work with for those longer term positions.

This past Sunday (April 11th 2010) in the ongoing Extended Learning Track (XLT) program, we had our usual Trading and Analysis session to look for the best high probability, low risk opportunities at the start of the new Forex trading week. Upon the market open, we were faced with some very significant gaps in a variety of currency pairs. This was caused by the weekend news which reported that there had finally been a bailout rescue package agreed for Greece and so the market saw this as good enough reason to buy back Euros, creating a large gap up in price on EURUSD of around 150 pips, as we can see from the chart below:


Significantly, this excess demand for Euros also triggered a sell-off in the US Dollar, which created a ripple effect across other pairs like GBPUSD, USDCHF and AUDUSD, albeit much smaller gaps in comparison:


As we can see from this chart of AUDUSD, the gap was around just 50 pips, much smaller in comparison to the EURUSD gap, yet significant nevertheless. Now upon seeing these gaps in the various currency pairs, the astute students in my XLT room sniffed out opportunity straight away and we immediately weighed the possibilities that the market was presenting to us. The first thought on their minds was, "Let's sell short," and I couldn't agree more. You see, the mindset of the XLT student is such that they fully understand that the consistently profitable trader needs only do two things to have an edge in the markets:

1. Understand the dynamics of Supply and Demand and recognize imbalances in this relationship on a price chart 
2. Make sure that they are taking the opposite side of the trade to the novice trader

The reason my students wanted to short EURUSD or AUDUSD was because they had gapped up on the open and only a novice trader would ever think about buying a market after a gap up in price. The buying had already taken place; hence, the gap up. The only way to ever truly make money in any market is to be one of the very first to buy or sell, not one of the last. Secondly, my students also wanted to find the right place to enter the trade and sell to the novice buyer. It then came down to finding the right entry that matched our criteria and taking the trade.

We decided on shorting the AUDUSD over EURUSD in the end. Now you may think why? After all EURUSD's gap was nearly 3 times as big as the AUDUSD gap, but the professional trader is not greedy and thinks about the risk and probability well ahead of the potential reward. Sure a gap fill on the EURUSD was a nice looking potential profit, but that was not enough to enter the trade, as we can see from the chart below:


The gap up in price on EURUSD was floating in the middle of key support and resistance areas, making this a higher risk trade. Price will always find its way to Supply and Demand levels in the end and if it's not already there, then the trade is a pass. I never want to be a buyer or seller in the middle of nowhere. This is impulsive and undisciplined and will never lead to consistency in trading. On the other hand, AUDUSD had a much better setup:


Unlike EURUSD, the AUDUSD gapped up into resistance of supply and understanding our rules to sell into an object area where supply has shown itself to be greater than demand made this an ideal opportunity for the XLT students to sell to the novice buyer, using a 30 pip stop, and targeting the gap fill and beyond. As we can see, the gap filled quickly and price moved from 0.9385 to around 0.9225 in less than 24 hours, giving at least a 5:1 Reward to Risk ratio on the trade.

Keeping it simple and understanding true price action is all it takes to be consistent in the markets. With a little discipline and the right education, we all have the opportunity to make trading work but only if we follow our rules and search for the lowest risk and highest probability trades available to us. While not as regular in the Forex markets, gaps can offer the trader some fantastic trading opportunities when they happen, but always remember to focus on the risk and stack the odds in your favor well ahead of focusing on the reward that you may or may not achieve.

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