A gap in forex trading refers to a situation where there is a significant difference between the closing price of one trading session and the opening price of the next. Gaps typically occur when the price of an asset moves sharply in one direction without any trading occurring in between, creating a “gap” on the price chart. These gaps can be caused by various factors, including market events, news releases, or changes in investor sentiment, and they often result in increased volatility.

In forex trading, gaps are less common than in other markets like stocks, since forex markets operate 24 hours a day, 5 days a week. However, gaps can still occur during market open after weekends or holidays, or after significant economic or geopolitical news.

Types of Gaps in Forex Trading

There are several types of gaps in forex trading, each with different characteristics and potential trading implications:

1. Breakaway Gap

A breakaway gap occurs when the price breaks through a significant support or resistance level, often indicating the beginning of a new trend. This type of gap is typically seen at the start of a strong trend and can be caused by major news events, economic reports, or shifts in market sentiment.

• Characteristics: Occurs after a period of consolidation or range-bound trading, signaling a potential trend reversal or continuation.
• Implication: Indicates a strong move in the direction of the gap, often followed by a continuation of the trend.

2. Continuation Gap

A continuation gap (or runaway gap) appears in the middle of an established trend and suggests that the trend will continue in the same direction. This gap often occurs during high volatility or strong market momentum, confirming that the current trend is likely to persist.

• Characteristics: Occurs during a strong uptrend or downtrend, often followed by a surge in volume or momentum.
• Implication: Signals the continuation of the current trend.

3. Exhaustion Gap

An exhaustion gap typically occurs near the end of a trend and signals that the trend is losing momentum. It can often be followed by a reversal or significant correction. This gap tends to form when the market has become overextended or when sentiment shifts suddenly.

• Characteristics: Appears after a long trend, usually near the peak or trough, and may be followed by a sharp reversal.
• Implication: Indicates a potential trend reversal or slowdown in the market.

4. Common Gap

A common gap is a smaller gap that occurs frequently in the market but is often less significant in terms of its impact on the overall trend. These gaps often happen during periods of low volatility and are typically filled quickly as the market returns to its normal trading range.

• Characteristics: Smaller, less dramatic gaps that occur in the middle of a trend or consolidation period.
• Implication: The market often fills these gaps relatively quickly, meaning the price will return to the previous range.

How Gaps Impact Forex Trading

Gaps can be important in forex trading for a few reasons:

1. Volatility

Gaps often indicate an increase in market volatility, as prices may move sharply in one direction due to new information or market sentiment shifts. This can present both opportunities and risks for traders.

2. Market Sentiment

A gap can reflect a sudden shift in market sentiment, such as a positive or negative economic report, central bank announcements, or geopolitical developments. Understanding the context behind a gap can help traders predict the next price movement.

3. Trend Confirmation

Gaps, particularly breakaway and continuation gaps, can confirm the direction of the trend, giving traders a signal to follow the trend with potential trade entries. A gap in the direction of the prevailing trend can indicate a high probability of continuation.

4. Risk of Reversal

Exhaustion gaps, on the other hand, signal potential trend reversals. Traders should be cautious when trading in these situations, as the market may quickly move against the existing trend.

5. Filling the Gap

In forex trading, gaps often get filled, meaning that the price may return to the level of the gap before continuing in the original direction or reversing. Traders watch for this phenomenon, known as gap filling, as it can indicate short-term price movements.

How to Trade Gaps in Forex

Traders use different strategies when dealing with gaps. Here are some common methods:

1. Trend Following (Breakaway or Continuation Gaps)

When a breakaway or continuation gap occurs, traders may view it as an opportunity to enter in the direction of the new trend. The gap acts as confirmation of strong momentum, and traders will typically:

• Enter trades in the direction of the gap, using a stop-loss to limit potential risk.
• Monitor for continuation in the same direction, expecting the trend to persist.

2. Reversal Strategy (Exhaustion Gaps)

When an exhaustion gap forms, it suggests that the trend may be near its end, and traders may look for a reversal. In such cases:

• Wait for confirmation of the reversal, such as a price pullback or pattern indicating a trend change (e.g., a candlestick reversal pattern).
• Use tight stop-loss orders to manage risk, as these trades are often speculative and require careful timing.

3. Gap Filling Strategy (Common Gaps)

Many traders use the gap fill strategy, assuming that gaps will eventually be filled by price retracing to the level where the gap occurred. This strategy works well with common gaps:

• Enter trades when the price approaches the gap level, expecting the market to return to fill the gap.
• Set stop-loss orders just outside the gap to protect against further price movement if the gap is not filled.

4. Wait for Confirmation

Some traders prefer to wait for the market to show further confirmation before entering a trade based on a gap. This could include waiting for price action, volume analysis, or additional indicators to align with the gap’s direction.

Risks of Trading Gaps

• Unpredictable Price Action: While gaps can indicate strong momentum, they can also lead to unpredictable price movements, especially during periods of high volatility.
• Market Open Gaps: Gaps often occur at the market open, such as after weekends or holidays, which can lead to slippage and higher spreads.
• Trend Reversals: Not all gaps indicate continuation—some can be exhaustion gaps signaling a reversal. Misinterpreting a gap can lead to costly mistakes.

Conclusion

A gap in forex trading is a significant price move that occurs between trading sessions, leaving an empty space or “gap” on the price chart. Gaps can be a valuable tool for traders, offering insights into market sentiment, trends, and volatility. Understanding the different types of gaps—such as breakaway, continuation, exhaustion, and common gaps—can help traders develop effective strategies to capitalise on them. However, gaps also come with risks, including market reversals and unpredictable price action, so it is essential to apply proper risk management and confirm signals before trading.