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When learning about forex trading, beginners may often hear about market gaps and slippage. Both these phenomena are considered either unavoidable risks or great opportunities of traders when they enter the market. So, understanding two terms can help forex investors avoid trading mistakes.
Forex Market Gaps
Market gaps are empty areas in a chart caused by sudden breaks in price when no trading activities take place. Normally, forex gaps are implicitly considered “weekend gaps” as they mainly occur over weekends or holidays when the forex market is closed. In other words, market gaps frequently appear between the close of one candle (the closing price on Friday) and the opening of another (the opening price at 10 PM GMT+0 on Sunday).
Many investors fear market gaps because it results in slippage which would be explained later. If a speculator day trades foreign currencies – that is, he or she closes all positions within a day instead of leaving them overnight, they are not worried about rollover or any related risks such as slippage or market gaps. However, in the case of longer-term traders such as swing or position investors, even when they place a stop-loss order to prevent prices from moving too far away from acceptable losses, market gaps can render their positions filled at worse prices than expected.
For example, you swing trade EUR/USD and open a long position at 1.18661. Your trade setup tells that you are willing to lose 10 pips as the maximum, so your stop-loss level now is at 1.18561. Normally, when your trade reaches the level, it would be closed at that price. What if you enter the trade on late Friday and then keep it open over the weekend? When the market gaps down or the price falls to 1.18461 on Sunday, the position will be automatically executed at that current value. Consequently, you lose 20 pips which double the originally estimated figure.
In another scenario when the market gaps up, you previously placed a take-profit level at 1.18761 with the risk-to-reward ratio of 1:1. When the price rises to 1.18861, your take-profit order is also filled at the price, which leads to a significant profit of 20 pips.
Therefore, gapping in reality is a double-edged sword and the given example shows how it works. Further, this phenomenon is also recorded in other short timeframes such as right after the release of major news or in a one-minute chart. However, the gapping size in those cases is smaller than over weekends and then easily filled.
The Importance of Market Gaps
Market gaps play an important role in forex trading as they express market sentiments. In other words, gapping indicates “sudden” expectations of investors about changes in exchange rates of currency pairs, which therefore leads to big jumps in prices and creates a new trend.
In the context of weekend gaps when most forex brokers close their trading platforms due to the absence of major players such as banks, the value of foreign currencies is still affected by various factors and moves over weekends. However, it has not been updated on a chart until Sunday.
Accordingly, the market gaps either upwards or downwards. When the price suddenly goes up, it means no traders expect to sell currencies at the gap levels. Meanwhile, when the price gaps down, it means no investors are delighted to buy at the gap levels. Like in the picture below, the closing price of EUR/USD on Friday (November 20th, 2020) is 1.18579 and the opening price on Sunday (November 22nd, 2020) is 1.18540. This explains that no purchasers are willing to trade the pair at the price range from 1.18579 to 1.18540, which forces the pair’s value to depreciate to meet the demands of the market.
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Sometimes, after gaps, the price tends to move in the opposite direction and then fills the gap. This is called “price correction” which refers to reversing the main trend to fill the gap. However, gaps are not always filled immediately after they are formed. Thereby, how long gap filling will occur depends on which types of market gaps a trader faces.
Types of Market Gaps
Gaps are classified according to price patterns which tell forex traders whether gaps can be filled.
The breakaway gap
Breakaway gaps occur when the price breaks out of a consolidated trading range which is associated with some chart patterns such as support and resistance, triangle, cup and holder, wedge or others. This phenomenon is more frequently seen when a trader sees the price gaps below a support level or above a resistance level. Accordingly, the appearance of a breakaway gap is regarded as a way to confirm a new market trend.
If a trading volume is higher than average on a breakaway gap, the price shows a strong commitment to the breakout direction. In case of a low volume on a breakaway gap, the price, despite gapping above resistance or below support, cannot be sustained out of this range in the long run and will come back to the previous trading range. In this way, a failed breakout happens and brings losses to those betting on the breakout. Meanwhile, for those who wish to trade on a well-established trading range, failed breaks can be a good sign.
Having said that, many investors suggest that a breakaway gap cannot be tradable. In other words, a breakaway gap is hardly filled in comparison with other types of gaps, signaling speculators to stay out of the market.
The common gap
Also known as “trading gaps” or “area gaps”, common gaps occur in normal market conditions, even when there is no major news preceding them. These gaps are often seen during weekend breaks when events released from Friday to Sunday may be occasionally exaggerated, which leads to a jump in the price. Normally, common gaps are rather small and easily filled in a few days later.
The runaway gap
Called a “continuation gap” as well, a runaway gap is frequently observed in the middle of the price pattern. Particularly, after a bullish or bearish trend begins and exists for some time, any major news can motivate an increasing number of traders to join in the market because they believe that the trend will continue moving in that direction. This accordingly can result in a runaway gap in the middle of the existing trend.
Also, a continuation gap is less able to be filled as this phenomenon appears to determine the direction of the ongoing trend.
The exhaustion gap
Contrary to a runaway gap, an exhaustion gap occurs at the end of a long trend and plays as a signal for a reversal of the price movement. This phenomenon is commonly observed when there is a significant price increase or decrease.
Assume that a chart records an upward trend in price. At this time, a herd mentality of investors encourages them to follow the trend and then make currency pairs overbought. Gradually, buying power is weakened whilst many more sellers have aggressively entered the market. Consequently, when the market finds no buyer who accepts to purchase assets at an increased price, the price will make a final gap in the trend and then be reversed.
Market gaps can result in slippage which is a difference between the requested price and the one at which an order is filled. Taking back the example of EUR/USD, the stop-loss level of 1.18561 is your expected price. In case the market gaps down, your position will be executed at 1.18461, leading to a negative slippage of 10 pips. On the contrary, if the market gaps up, a 10-pip slippage will be positive because you requested a take-profit level of 1.18761 but then fill the order at 1.18861.
Therefore, similar to market gaps, slippage can either bring bigger benefits to forex traders or pose them to a higher risk of a loss. Accordingly, slippage would influence both stop-loss and limit (take-profit) orders and render those orders implemented at worse or better prices.
What Causes Gaps in the Forex Market?
Market gaps in the forex industry are caused by two primary reasons as follows:
The continuation of forex trading by institutional traders
The forex world includes a retail trading market where retail traders open an account with a brokerage company and an interbank market where banks exchange different currencies.
The first market is often closed over weekends, from 10 PM GMT+0 on Friday to 10 PM GMT+0 on Sunday. Accordingly, unless retail traders are high-net-worth individuals who own a trading account of at least US$1 million and prefer opening a position on weekends, they cannot access the market on those days.
Meanwhile, although there are no activities on trading desks of banks over weekends, institutional traders can be assigned by their banks or other financial companies (e.g. hedge funds) to participate in the market in exceptional circumstances, for example, before the US election results are announced. Further, there are also currency conversion transactions of large commercial corporations or bureaux de change for different purposes on weekends. Therefore, in nature, the interbank market works 24/7 and such continuous trading activities make values of currency pairs keep fluctuating. Consequently, weekend gaps occur.
The release of unexpected news
The forex market is affected by economic or political events. Particularly, the release of major news that the market is not expecting can change supply and demand for foreign currencies, thus influencing their prices. Thereby, the important news announcements can cause market gaps, even on weekdays.
Generally speaking, market gaps in the forex market do not take place so often as in the stocks market. However, it does not mean you can ignore their possible impacts. Observing an economic calendar and a chart would provide a proper fundamental and technical analysis for traders to trade on market gaps.
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