Gaps are areas on a chart where the price of the currency (or other financial instrument) shows a sharp move up or down, accompanied by little or no transaction volume. As a result, the chart shows a “gap” in the normal structure of currency prices. The enterprising forex trader may interpret and exploit these vulnerabilities to their advantage. This article will help you understand how they form and how they can be used to conclude profitable trades in the forex and stock markets. Playing gaps is such interesting forex strategy that it should appeal to both investors preferring technical analysis, as well as those that make their decisions based on fundamental analysis.
Basic information about the gaps
Gaps are a result of underlying fundamental or technical factors. For example, in a situation where company profits far exceed the expected revenues, the shares of such a company can create a gap next day. That is, the opening prices are higher than the ones on the closure of day before, thereby creating a gap. On the forex market, it often happens that the announcement of the report causes so much confusion that it may contribute to an increase in the difference between the bid and ask price (bid and ask spread), up to the point where there is a significant gap. Similarly, the share price reaching a new high point in the session can record even higher opening price in the next session, thereby creating the technical gap.
Gaps can be divided into four following groups:
• Breakaway gaps are the gaps that appear at the end of price formation, indicating the emergence of a new trend.
• Exhaustion gaps appear at the end of the price formation indicating a final attempt to reach a new highest or lowest values.
• Common gaps are the gaps that can not be put in the price formation – they represent just an area where the price has created a gap.
• Continuation gaps appear in the middle of the price formation marking the high activity of buyers and sellers who share the same opinion on the future direction of the price movement of a stock.
To fill or not to fill
When someone states that the gap has been filled, it means that the price returned to its original level, before it gap appeared. These fillings are quite common and are the result of the following factors:
• Irrational exuberance: The initial spike turned out to be too optimistic or pessimistic, thereby encouraging correction.
• Technical resistance: In the case of very sharp rises or falls, there is no place for support or resistance.
• Price pattern: It is normally used to classify gaps and informs investors about whether the gap can be filled or not. Exhaustion gaps generally show the highest probability of fulfilling since they announce the approaching end of the trend, while the continuation gaps or breakaway gaps show a much lower probability of meeting as they are used to confirm the direction the current trend.
If the gaps are filled during the same session, as the date on which they occurred, this phenomenon is called fading. For example, suppose that a company announces a high profit per share for the quarter and that upward trend gap appears on the opening day (which means that the opening price was significantly higher compared to the previous closing prices). Let’s just say that over the day, the players realize that a published report of financial flows shows a weakness and begin to sell the shares. As a result, price reaches the point of the previous day’s close and the gap is filled. Many forex market participants apply this strategy in the period of price increases (earnings) or other periods in which unjustified plenty reaches the highest value.
How to play gaps?
There are many ways to use the gaps phenomenon, and a few strategies are particularly popular. Some players will acquire shares in circumstances where the fundamental or technical factors will indicate the possibility of gaps in the following day. For example, in the case of a notice of the report on the positive profits, they are buying shares after the closing of markets, in hopes of an gap appearing on the next day. Traders can also acquire or sell shares as a liquid positions at the beginning of the price movement, in the hopes that they will benefit from filling the gap, and that the current trend remains. For example, you can buy the currency if quickly creates a gap of a bullish prices combined with the low market liquidity and where there is no significant resistance point (resistance overhead).
Some players will fill the gap in the opposite direction after determining the highest or lowest price (often through the use of other forms of technical analysis). For example, if the action creates a bullish gap on the basis of a speculative report, experienced players can fill this gap by reducing their positions (shorting the stock). At the end, players can also acquire the shares when the price reaches the previous point of support after you filling the gap. Below is an example description of this strategy.
Here are some of the key points that you need to remember while playing on the gaps:
• Once you start filling in the gap in the price of the shares, this process is rarely stopped due to the frequent lack of direct point of support or resistance.
• Exhaustion and escape gaps allow you to anticipate price movement in two opposing directions – you need to make sure, that there had been a proper classification of gap that you plan to use.
• Retail investors are the ones who usually exhibit irrational abundance, but institutional investors can also use this method to improve their wallets – one should therefore be careful when applying this indicator and make sure that it follows the break prices, before taking a position.
• You should also pay attention to the volume. High volume should appear in the breakaway gaps, and low in exhaustion gaps.