The beginning of a new month/year is the perfect time to talk about Forex gaps. A look across the market shows several year-open gaps – some big, some small. However, these aren’t the only gaps you should be paying attention to.
Why are gaps so important, you ask?
Simply put, gaps can provide you with extra confluence when drawing support and resistance levels. As you may well know, the more confluence you have at a particular level, the more likely that level is to hold. Combine that with a valid price action strategy and the right amount of bullish or bearish momentum, and you have a winning combination.
In this lesson, you’re going to learn what gaps are, why they form as well as how to use them to increase your odds of success. We’ll also cover a little-known way to use gaps to identify buying and selling opportunities.
What is a forex gap?
Before we start talking about the technical benefits of gaps, it’s important to first know how to identify them on a chart.
The best way to illustrate the gap is to show it in action. Below is a daily chart of EURUSD which shows several gaps that formed over the course of three months.
Notice in the chart above, the market formed several gaps where the opening price was above or below the previous closing price. This represents a gap in the market.
Why Do Gaps Form?
First things first. The Forex market never closes, not even on weekends or holidays. A common misconception among Forex traders is that the market is closed over the weekend. In fact, only Retail trading is closed on weekends. The Forex market as a currency exchange is alive and well.
Which brings us to an important discovery about gaps – they don’t exist. At least not in the way a lot of folks like to think they do, which is that a gap is created by the market.
Instead, it’s actually your broker that is responsible for the gaps you see on your charts.
When retail trading closes for the weekend, your broker simply denies you (the retail trader) the ability to trade. This is why the size of gaps will often vary from one broker to the next.
To the retail trader viewing a chart after 5pm EST on Friday, it appears that the market is closed. In reality, the market is still moving behind the scenes, producing new bid and ask prices all weekend long. When retail trading opens on Sunday, a different price from that of Friday is often shown, thus creating the gap you see on your chart.
Although the Forex market is open over the weekend, there isn’t much movement due to the decrease in volume. This is why smaller gaps of ten or twenty pips are far more common than gaps of fifty pips or more at the start of a new week.
There are three main types of gaps that can form:
Weekend Gaps
These are the gaps that form due to market movement during the weekend. They represent the difference in price from 5pm EST on Friday, when retail trading closes, to Sunday at 5pm EST when retail trading resumes.
With fifty-two weeks in a year, these are also the most common gaps found in the Forex market. So while they can provide confluence to an already-established level in the market, they are not the most influential compared to the next two.
Month Open Gaps
These gaps occur between the closing price of one month and the opening price of the following month. It’s important to note that a month open gap only forms if the new month begins during a weekend. It is possible for a gap to form if the new month begins on a weekday, however, it’s rare for these to produce a substantial gap in price.
With just twelve months in a year, these are gaps you don’t want to miss.
Year Open Gaps
As the name implies, year-open gaps form at the onset of a new year. Because retail trading is closed for the holiday on January 1st, and because most large players like to unload their positions before the year’s end, a substantial gap in price can often be found when retail trading resumes on January 2nd.
These are the king of gaps. A year-open gap will often influence a market for years to come.
The “unclosed” gap is a gap which forms and is left open for more than one week. In other words, it takes the market more than five trading days to fill the gap. These can be weekly, monthly or even yearly gaps.
Do keep in mind that the significant gaps occur at higher time intervals. This means that a year open gap will be more significant than a month open gap, just as a month open gap will be more significant than a weekend gap.
Let’s take a look at an example of an unclosed gap that formed on AUDUSD.
Notice in the chart above, AUDUSD formed a large month-open gap in price, gapping down almost 50 pips. It took the market eleven trading days to fill the gap. As soon as the gap was filled, the market continued (aggressively) in the direction of the gap.
Here’s another example of an unclosed gap. This time, we’re looking at a week open gap that occurred during a GBPUSD rally.
This 60 pip gap formed during a strong rally. The gap went “unfilled” for 50 days. As soon as the market filled/closed the gap, the market continued its aggressive rally.
So what’s the “game plan” for trading an unclosed gap?
In cases such as the two unclosed gaps above, you can simply set a limit order to buy or sell the gap’s originating price. This means you would look to buy or sell as soon as the gap is filled.
The two setups above worked out well for three reasons:
The market had established a strong trend prior to forming the gap
Both gaps went unclosed for more than five trading days
At 50 and 60 pips, these gaps were obvious to market participants
This brings us to an important conclusion about trading unclosed gaps. They can be extremely profitable and provide precise entry levels. However, there are other factors that must be present for the strategy to be considered favorable.
Using the Forex Gap at Key Levels
So far we’ve talked about what a gap is and why it forms as well as the three different types of gaps – weekly, monthly and yearly. We’ve also covered how to trade unclosed gaps.
Let’s wrap things up by taking a look at how these gaps can be used when identifying key levels in the market. As you may well know, your success as a Forex trader greatly depends on your ability to identify levels in the market that are likely to produce a reaction, also called support and resistance levels.
As I mentioned at the beginning of this lesson, gaps in the Forex market can provide you with extra confluence when drawing these levels.
Let’s take a look at an example!
Notice in the NZDUSD four-hour chart above, we have a key level that formed in combination with a week open gap. This level later acted as resistance as sellers began to take control of the market.
It’s important to note that the week open gap in the chart above was not the only confluence factor at work. This level had already been established as a key support area. However, the addition of the gap meant that the level was more likely to hold in the event of a retest as new resistance.
Conclusion
Gaps can be a powerful asset to the price action trader. They provide added confluence to an already-established level in the market, which can help to put the odds in your favor.
Just remember these important points when using Forex
gaps to your advantage:
The larger, more obvious gaps are more likely to produce a change in direction
Gaps that occur at higher time intervals are more influential than those that occur at lower intervals
An unclosed gap is one that is left unfilled for more than five trading days
When using gaps as added confluence at key levels, just remember that the level should stand on its own as a key support or resistance level
The next time you open up your charts, be sure to take note of any obvious gaps. They just might provide you with a viable trading opportunity.
Your Turn
Do you use Forex gaps when identifying key support and resistance levels? Let me know your thoughts by leaving a comment or question below.
Talk soon.