Hey Guys,
This Sunday (2012-05-06) EUR/USD opened at 1.3011, 71 pips below last weeks close of 1.3082. This is the largest weekend gap on EUR/USD since November 25th 2011. Whenever the Forex market opens with a large gap I get a barrage of emails about gap trading in Forex.
The conventional wisdom in Forex is that gap trading is highly profitable and easy. In this post I take a look at just how reliable and easy gap trading is.
What Is Gap Trading?
Gaps are empty spaces between the close of one candle and the open of the next. In Forex gaps are not very common and they usually only occur at market open on Sundays. These gaps occur between a pairs close price on Friday and it’s open price on Sunday.
Stock and commodity traders have been exploiting gaps for decades. Since the stock market closes each day gaps are much more common. The concept behind gap trading is that price will always try to fill the gap. This may sound illogical but there are some logical reasons for price to fill gaps in the stock market. Generally when price gaps there is no support and resistance in the gap area. This means that price has free room to move inside the gap.
Over the past few years people have started trading Sunday evening gaps in Forex. The concept is the same, gap traders think that price will always fill a gap.
Does Price Always Fill The Gap?
Technically speaking price always fills the gap, but this doesn’t really mean anything. Every Sunday gap seen this year has been filled but one trade moved 306 pips on the opposite direction before the gap was filled two weeks later. Another gap was filled within two days but the price move 87 pips on the opposite direction before returning to fill the gap.
So even though gaps are almost always filled trading gaps in not always viable.
A Closer Look at Gap Trading
I have compiled statistics in order to analyse the profitability of gap trading. The statistics are of gaps in 2012 on the EUR/USD pair.
The System
To compile these statistics I needed a basic gap trading system. For the purpouses of this analysis I decided to use a very basic system.
Pairs: EUR/USD
Target: Size of gap.
Stop: 50% of target.
Entry: Provided the gap is 20 pips or wider trades are entered as soon as the market opens on Sunday.
Exit: As soon as target or stop is hit.
Broker
For the analysis I used my main broker GFT Forex. Since the Forex market has no central exchange there is no official open or close time in Forex. This means that gaps may appear different dependant on your broker. This could lead to different results than the ones below.
Results
| Date | Gap | Close | Open | Target | Stop | P/L | +45 |
|---|---|---|---|---|---|---|
| 2012-01-08 | 22 | 1.2715 | 1.2693 | 22 | 11 | -11 |
| 2012-01-14 | 45 | 1.2679 | 1.2634 | 45 | 22 | 45 |
| 2012-01-22 | 53 | 1.2930 | 1.2877 | 53 | 26 | 53 |
| 2012-02-05 | 43 | 1.3156 | 1.3113 | 43 | 21 | -21 |
| 2012-02-19 | 42 | 1.3138 | 1.3180 | 42 | 21 | -21 |
| 2012-03-11 | 20 | 1.3123 | 1.3103 | 20 | 10 | 20 |
| 2012-04-01 | 25 | 1.3335 | 1.3360 | 25 | 12 | -12 |
| 2012-04-22 | 27 | 1.3210 | 1.3183 | 27 | 13 | 27 |
| 2012-05-06 | 71 | 1.3082 | 1.3011 | 71 | 35 | -35 |
Five out of the nine trade were losses. Best case scenario, trading gaps using this system would give you a 50% chance of winning a trade. Win rate aside, the system is profitable by +45. This is attributed to the win loss ration of 2:1.
These stats show how unreliable gap trading can be. This year we have had nine gaps, eight of those gaps have been filled and one remains unfilled. The table below shows you the floating pip loss you would have needed to endure for each gap to close.
| Date | Gap | Close | Open | Target | Max Float |
|---|---|---|---|---|---|
| 2012-01-08 | 22 | 1.2715 | 1.2693 | 22 | 29 |
| 2012-01-14 | 45 | 1.2679 | 1.2634 | 45 | -10 |
| 2012-01-22 | 53 | 1.2930 | 1.2877 | 53 | -3 |
| 2012-02-05 | 43 | 1.3156 | 1.3113 | 43 | -87 |
| 2012-02-19 | 42 | 1.3138 | 1.3180 | 42 | -306 |
| 2012-03-11 | 20 | 1.3123 | 1.3103 | 20 | -0 |
| 2012-04-01 | 25 | 1.3335 | 1.3360 | 25 | -15 |
| 2012-04-22 | 27 | 1.3210 | 1.3183 | 27 | -2 |
| 2012-05-06 | 71 | 1.3082 | 1.3011 | 71 | -101 |
Three of these nine trades required a floating loss of more than -50 pips before the gap was filled. It is illogical to leave a trade open for -87 pips in the hope of making 43 pips when the gap is filled. One of the trades had a -306 pips floating loss and the one that is currently has had -101 pips. So even though most gaps are filled some require you to suffer large floating losses before being filled.
Is Gap Trading In Forex Profitable?
In my opinion gap trading isn’t a viable in Forex. However, I have only tested one pair with four months worth of data. To be definitive I would need to test at least five pairs with one year of data. I might do this in future but at the moment it is more important to address the flawed wisdom in the Forex community.
GAPS ARE NOT ALWAYS FILLED QUICKLY!
Yesterday I was asked on my blog if I considered shorting EUR/USD risky because there was an unfilled gap above my short. If I see a good trade I wont let an unfilled gap keep me out of the market. The statistics make it clear that gaps are not always filled quickly, so they should not impact my trading decisions.
I think the prevailing wisdom about gap trading in Forex is wrong. While it might be possible to make some profit trading gaps it is not as easy as people suggest. So next time somebody tells you that the price has gapped so you should trade the fill, tell them that gap trading is a roll of the dice.