Encountering Gaps in the Financial Markets

Veteran traders in the financial markets are likely familiar with the occurrence of gaps. A gap is characterized by a significant space between the closing price of one trading period and the opening price of the next. While these events can heighten risk due to their unforeseeable nature, they also present opportunities for profitable trades.

Gaps manifest on trading charts as zones where no trading takes place, indicating a lack of orders at those price points. This absence of trade suggests that no traders were willing to engage at those levels, or those interested could not find counterparties.

In extreme cases, gaps can be substantial and potentially damaging. However, they are typically small, with no trades executed, and can be utilized strategically by traders.

When Gaps Emerge

Gaps are a common occurrence in the markets, particularly for traders with positions open over weekends or during significant news events. In forex, which operates 24/7, gaps are less frequent, with most occurring over weekends. For stocks and commodities with set trading hours, gaps can appear between trading days when markets are closed.

Another scenario for gaps is during the release of important news. In forex, this could be macroeconomic data releases, while in equities, gaps might result from company-related news. Commodity markets can be especially susceptible to geopolitical events and related factors.

Traders often have adverse experiences with gaps, especially when they occur during trading hours due to unexpected news. If the gap causes a price movement opposite to the trader’s position, it can lead to significant negative slippage. The risk is that even with a properly set stop loss, the slippage from the gap can substantially increase losses. Conversely, if the gap moves the price in the trader’s favor, positive slippage can result in higher profits than the original Take Profit would have yielded.

Gaps are significant for traders using technical analysis as they signal shifts in market sentiment and changes in supply and demand dynamics. Experienced traders can leverage these insights to their advantage, depending on the gap’s location and the stage of the trend.

Common Gaps

Common gaps arise in less active markets and are not of great significance to traders as they are not linked to significant news or events. They usually fill in quickly (the price returns to the gap’s creation level) and do not serve as reliable indicators of future price movements. They can occur during trending or sideways market movements and represent short-term liquidity shortages.

Common-gap

Breakaway-Gap

Runaway/Continuation Gaps

These gaps form during strong trends with minimal corrections. Similar to breakaway gaps, they do not fill but differ in their location within the trend. Unlike the former, this gap indicates an upward trend, appearing mid-trend, potentially triggered by news confirming the trend or increasing trader interest in an ongoing trend they joined late.

As with the previous type, trades should be opened in the direction of the gap, with Stop Loss placed below the gap in a bullish trend and above the gap in a bearish trend. Since this gap often occurs mid-trend, it can indicate the trend’s duration.

Runway-gap

Exhaustion Gaps

Exhaustion gaps, as the name implies, appear at the end of a trend or at significant support or resistance levels. Inexperienced traders might confuse them with runaway gaps, as they form in the trend’s direction, potentially leading to new highs or lows. These gaps are driven by increasing trader interest in the trend.

However, unlike other gaps, exhaustion gaps are filled, and the trend reverses. A key difference from a runaway gap is the significant volume, which dissipates quickly. Experienced traders monitor both price and volume, anticipating a trend reversal if the gap’s volume increases markedly. They place orders accordingly, setting stop losses above the gap in a declining market or below the gap in an advancing market.

Exhaustion-Gap

Gap charts can provide valuable insights into market sentiment and price movements but are not recommended for less experienced traders. Those who can distinguish between gap types and understand their origins and impacts can use them advantageously. However, even with gap trading, adhering to risk management rules is crucial due to the unpredictability and increased volatility associated with these situations. Trade safely!