Gap trading — how price gaps work in theory and practice

On Sunday, 24 June 2016, a few hours after the Brexit referendum result came in, GBP/USD opened the new week at 1.3650 — almost 800 pips below Friday's close of 1.4880. A trader holding a long position with a stop at 1.4820 never saw that protective order fire at the intended level. The broker filled it at the first available quote, and a small planned loss became a far larger one. That night it became clear what a price gap really is, and why for some it is an opportunity and for others a catastrophe.

What a price gap actually is on a chart

A price gap is a break between one session's close and the next session's open in which no trading takes place — on a candlestick chart you see it as an empty space between two candles. On the stock market this is an everyday event, because the exchange runs for only part of the day, so each morning the price can open above or below yesterday's close. On forex the picture is completely different, and that difference is the key to the whole subject.

The currency market trades almost without interruption from Sunday evening to Friday evening — roughly 24 hours a day, five days a week. When quoting barely stops, there is little room for gaps: a meaningful one appears on forex mainly once a week, at the weekend break between Friday (22:00) and Sunday (23:00 CET). That is why gap trading is primarily a stock-and-index phenomenon, and on currencies it really comes down to weekend risk. Small, momentary gaps can also form the second a major data release hits, when not a single order between two prices is filled.

Four classical gap types

Classical technical analysis has for decades worked with four kinds of gap, described among others by John Murphy and Thomas Bulkowski. Each forms in a different context, carries a different message and has its own probability of being filled, and the whole strategy rests on correctly diagnosing the type of gap in front of you.

Why common gaps fill so often

The mechanics are rooted in market microstructure. When quoting opens with a gap, an empty zone with no resting orders is left near the previous close, and that zone acts as a magnet — both sides' stop losses got trapped there, and capital hunting for liquidity pulls price back to the last traded level. Drawing on more than a thousand cases, Bulkowski shows that most small gaps fill within a week, though the exact percentage varies with the type of gap and the instrument.

There is a trap hidden here. The tendency to fill is not a law of physics but a statistic — and statistics have a tail. The gaps that do not fill are precisely the cases in which a strong trend returns after a quiet stretch and a supposedly contrarian position turns from a small loss into a catastrophe. On the majors the weekend gap is usually small and returns to Friday's close in most calm weeks; on exotics it can be far larger and may stay away for months. That is why, even with a high fill rate, the stop must be hard and position size must respect the one-percent rule on every trade.

How to trade the weekend gap (and when to avoid it)

Trading for the gap to close, the "fill the gap" approach, is the simplest way beginners try to make money from gaps on the currency market. The logic is plain: since most small gaps close, you open a position towards Friday's close and wait for price to return there. In practice the result is decided by which weeks you trade and by the stop loss, not by the entry. The example below is hypothetical and illustrative.

Picture a calm Sunday with no important events. At 23:00 CET, EUR/USD opens with a gap down of a dozen-or-so pips against Friday's close. The trader waits five minutes to confirm the gap is settling, then goes long towards Friday's price. The take profit sits at Friday's close (a few pips earlier, to absorb the spread), and the stop a dozen-or-so pips below the Sunday open, ideally guaranteed. If the gap has not closed by Wednesday, the trader exits near the entry — no finesse, just discipline.

The most important rule is this: you do not trade every Sunday. You skip weekends that carry elections in a major economy, political summits (G20, Davos), military escalations, announced referendums, or situations in which a G10 central bank might take an emergency decision. That filter protects your capital — and it is exactly what was missing in the story at the start of this article, where the Brexit referendum weekend carried a gap risk no ordinary stop could contain.

Breakaway, runaway and exhaustion gaps in practice

While a common gap is a contrarian opportunity, breakaway and runaway gaps are signals to follow the move. A breakaway gap forms when price breaks an important level after weeks of consolidation, on elevated volume, and usually does not fill for a long time; you enter in its direction, with the stop behind the consolidation range. The runaway, or measuring, gap appears around the halfway point and hints the trend still has fuel. Most treacherous is the exhaustion gap, which ends a long move on extreme volume and warns of a turn; when it is quickly closed and a second gap forms the other way, the chart prints an island reversal — one of the strongest reversal signals in technical analysis.

"Of the three types of gaps, the breakaway, the runaway, and the exhaustion gaps have the most forecasting value. The exhaustion gap occurs near the end of a market move and represents a last gasp in the trend." — John J. Murphy, Technical Analysis of the Financial Markets, New York Institute of Finance, 1999.

Three classic mistakes in gap trading

Gap trading looks appealing because of its objective rules, but the market tests theory mercilessly, and three mistakes consistently drain beginners' capital.

• Ignoring the weekend event calendar. The best hit rate falls apart when, once every few months, a crisis gap of several hundred pips arrives — a single such position can wipe out the gains from many successful trades.
• Confusing gap types. Anyone applying a "buy every gap down" rule gets destroyed during a strong downtrend, because every successive gap is in fact a breakaway or a runaway gap.
• Tight stops without guaranteed execution. A stop placed right behind the entry is almost certain to be taken out by noise, and during a crisis gap it will be filled with slippage far worse than intended.

What to do this weekend

You will learn the most by treating the weekend gap first as a question of risk, and only then as an opportunity. The steps below let you start in a controlled way, without exposing capital to a risk you do not yet understand.

1. Open a daily EUR/USD and USD/JPY chart covering the last year, count the weekend gaps and check how many closed within the next five sessions — this gives you a real picture of the statistics before you risk your own money.
2. Look at the calendar for the coming weekend and note any elections, political summits, referendums and central-bank meetings; if anything on that list falls on Saturday or Sunday, drop the fill-the-gap trade for that week in advance.
3. Check whether your broker offers a guaranteed stop loss and what it costs, because without that protection an ordinary stop during a crisis gap will be filled at the first available price, well below the level you intended.
4. Practise the whole plan on a demo account for at least ten weekends, recording the gap size, direction and result, and move to a small live account with one-percent risk per trade only once your hit rate holds above sixty percent.
5. Before your first real entry, review the rules of weekend trading and the definition of the phenomenon itself in what a price gap is, so you understand the full mechanics and risk before you put real money on the line.

Once you have mastered the common gap, the natural next step is trading with the trend — it is then worth studying strategies built on breakaway gaps, such as the Upside Gap Three Methods formation and its mirror image, Downside Gap Three Methods.