A “gap” in the market is the price movement of an asset, including a currency, stock, commodity, etc., during a period when no trading has occurred. Most commonly, gapping in the market is seen in the difference in price of the asset between its closing price at the end of one trading period and its opening price in the next trading period, such as overnight or over the weekend. However, gaps can also occur over shorter time frames, which is what some day traders use to make trades.
If you’ve used a subway train you’ll be familiar with the gap between the platform and the train. This is needed to ensure the train slides past the platform without crashing into it. Gapping in the market occurs due to various factors, including the regular buy and sell pressures, political and economic events, economic or policy announcement by a country, market sentiment, acts of terrorism, natural disasters, or for that matter any news event that is of high impact for a nation. Like the subway train and platform, these gaps in market prices allow certain events to slide past without crashing into an asset’s value.
In short, gaps are most often created by fundamental changes, making it all the more important for traders to remain updated with the economic calendar, as well as other geopolitical events.
Gaps can be either a down gap or an up gap. The former occurs when the opening price is lower than the closing price, while the latter occurs when the opening price is higher than the closing price of the previous trading session. While this is broadly how gaps occur, gaps are classified into four types:
The trading strategy typically used to benefit from gaps is to borrow short and lend long. This helps the lender gain better interest rates, since short rates are usually lower than long ones. However, whether you take a long or a short position would depend on the type of gap identified. For novices, if you are unsure about trading gaps, you could also use it as a confirmation signal for your trading decisions. For instance, if you identify a break away gap, you know that an uptrend is beginning and can then base your trading decision, using other indicators and analyses, with the uptrend in mind.
On the other hand, if you are worried about limiting risks, normal stop orders can help. However, while stop loss orders do help manage risk, they are not infallible and there are times when the market could shoot past your stop. At such times, it is best to close the trade at the best available price, which could be different from your trigger value.
You could also consider guaranteed stops to protect trades against gapping in the market. While these work in a similar way to the normal stop loss order, they guarantee that a spread trade would be closed at the set trigger value, regardless of gapping or any market volatility.
The bottom line is that while you can take advantage of gapping, it is best to use risk management tools, regardless of what trading strategy you use.
If you liked this educational article, please consult our Risk Disclosure Notice before starting to trade. Trading leveraged products involves a high level of risk. You may lose more than your invested capital.
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