I’ve had quite a few emails about gap trading so I thought I’d write an article with some of the gap trading strategies I know work and generate profits.
I’m going do the following:
- Explain what gaps are
- Explain why they present an opportunity
- Teach you strategies to who take advantage of them
What is a gap?
A gap is where the market closes and opens at a difference price / level. You can
see these gaps (depending on the market) and the basic theory is that these gaps like to close (due to pricing imbalances).
This presents us with an opportunity to trade.
Market hour gaps
Most financial markets open and close at different times depending what they are. Cryptocurrencies are unique insofar as they are open all the time so this doesn’t apply to them.
Index / stock markets close every day and over the weekend.
Forex markets close at the weekends.
When these markets are closed things and events happen that result in the price opening away from where the market closed.
The German stock market, the DAX 30 is a great example of a market that gaps (the gaps are also clear when looking at direct data feeds from the exchange, but we don’t need to go in to that).
The DAX opens at 08:00 (GMT) and closes at 16:30 (GMT). That’s what creates the gaps below.
You may not see weekday gaps if you’re trading indices on a CFD or Spreadbet broker platform. This is because they’ll be tracking other worlds indices.
What does that mean? Well when the FTSE is closed the Chinese, Japanese and Australian markets will be opened and moving. The Futures markets will also be open.
I totally disregard this out of hours data. I actually pay for a data feed direct from the exchanges so that data is automatically disregarded. You may be able to disregard that data on your chart settings if not you can just do it manually.
This screenshot from MT4 is showing the same data as the above screenshot, but there are no gaps due to the out of hours data.
The way to work around this is to simply look at the relevant candles and disregard everything else. Go on to a 5 minute chart and do the following:
- Search for the market in question in Google. You’ll get a result like Yahoo Finance.
- Look at the closing price of the previous day’s trading.
- Mark this up with a horizontal and vertical chart lines.
- Compare this with the next day’s open.
You then have the closing / opening gap marked on your charts.
Why are we interested in gaps?
Great, so we have market gaps, why should that interest you?
Well quite simply gaps often close, especially when they are on the smaller side. We don’t need to go in to the potential reasons why. Who cares as long as it provides us with an edge?
Here are some examples on the DAX of gaps closing.
So how can we trade these?
It’s one thing knowing that gaps have a good chance of closing, but it’s not as simple as merely trading in the direction of the gap.
Hopefully this won’t come as a surprise. We need to have some strategies to get on board of a potential gap close.
Take this example:
The market starts by gapping down. We cannot just go long and hope the market will close its gap. We need a trading strategy to do so.
The market begins to recover and we see a triangle wedge occurring. Triangle wedges are a price action pattern that we look for.
In order to take advantage of both the gap and the triangle wedge we would use the breakout trading strategy we use to take profitable trade.
You can learn how to trade breakouts which you can use to trade gap closes then the setup occurs.
DAX gap trading strategy
DAX gaps very clear due to the way the exchange operates. We are able to clearly see the opens and closes and use them to line-up potential trades.
Have a look at this image again:
See how clear the gaps are? We know exactly where the market has opened and closed. This allows us to plot our visualise where we may want to take a trade.
DAX gap edge
Other uses for gaps
We can use gaps to place stop losses and profit targets depending on the strategy we are trading. For example if we have an idea a gap may close we could place a profit target near where it closes to squeeze a little more out of the trade.
Look at the picture above. There is the gap and then the gap close. Look how the gap close acts like a support level, where the market bounces off from it. The ideal position to place a profit target, if short, would be just above the gap close.
Now flip over the scenario, imagine you were long previously. You could place your stop loss a little below the gap close in case it became a support level.
Gaps are part and parcel of trading. They wonk best on indices and especially the DAX.
Consider how you can place stop losses and profit targets based on gap behaviour and look to take advantage of breakout trades.
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