Currency Trading Strategy

- Trading with Gaps -

Ever find a significant difference in price when the market opened the following session?  This can be quite disconcerting if you had an open position at the close of the previous session.  What we are talking about here are called gaps.  They are the result of something happening – news, or whatever - between the close of one session and the open of the next.

Now that 24-hour trading and extended-hours trading are here to stay, it is not unusual to come across significant changes in price at the open of one session from the previous session’s close.  All markets have their specified times for trading.  Each market has its own opening and closing times, called market hoursor pit session.  Some markets are open for eight hours a day, while others are open for a shorter period.  And then you have the Forex market that literally follows the sun around the World. 

Examples of different trading times include the foreign currencies that trade at the IMM in Chicago from 7:20 am Central Time to 2:00 pm, while the live cattle market opens at 9:05 am Central Time and closes at 1:00 pm.

What is happening around the world between the market's close and the next session’s open can have a dramatic effect on how the markets open.  A market can open at a different price from the previous session's close due to events or reports that come out while it is closed.

An example would be a company announcing its earnings after the bell-- that is, after the stock market closes.  If those earnings are lower than was expected, sellers will react to this perceived weakness in earnings, and drive prices down.  This causes prices to open somewhat lower than the previous session’s close.

GAPS

Essentially, a gap is an area where no trading has taken place.  An opening up gap is where the market opens higher than the previous session's high.  An opening down gap occurs when the market opens lower than the previous session’s low.

Gaps can catch you off guard.  You could easily have a favourable position going into the close, only to wake up the next morning to find that the market has gapped against you.  What is even more frustrating is when the market gaps straight through your stop price, giving you a bigger loss than you expected.

                                                                                                         X   Y                Z

(Chart courtesy ProphetCharts.com)
 
Every so often, gaps will occur, and they can open up or down.  The figure above displays an example of the most recent down gap (January 25th, 2002) for the Swiss Franc at the spot marked Z.  The size of a gap can have some effect on price direction.  Generally speaking, if a gap is relatively wide, some traders will tend to fade it -- that is, trade against it.  A gap over a certain amount or percentage indicates that the market has overreacted, or that illiquidity of the after hours market has taken over.  If the gap is up, some traders will sell at the open in anticipation of the market either closing the gap, or at least settling down to some extent.

In the above example, you can see that the gap created at the spot marked X -- December 24th, 2001 -- was filled in December 31st, 2001 -- at the spot marked Y.  Gaps like to be filled in, from a trading perspective -- and usually are.  The gap of January 25th, 2002 -- at the spot marked Z -- will also be filled in sooner than later.

If you understand this phenomenon, you can easily see how you can make money by anticipating such a move, either on the day that it occurs or subsequently thereafter -- in a matter of days.

If the commercial traders just happen to be long with their futures positions at the same time such a gap occurs, as on January 25th, 2002, then fill your boots sports fans.  Prices have nowhere to go but UP!

Trading with gaps is not just something that works with currencies.  It is a strategy that you can use with any market, including commodities, indexes, and stocks.

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