Price gaps are a common phenomenon in financial instruments and are reflective of a substantial change in the underlying technical or fundamental outlook. This is a pattern that occurs across almost all financial assets including foreign exchange, stocks, commodities, and futures. A price gap is typically indicative of a widening of the spread that occurs after a major announcement. For stocks this could result from earnings while for FX this could imply economic news that surprised markets.
These particular trading situations arise frequently and are formed by the confluence of fundamental and technical factors, making them particularly attractive swing trading opportunities. There are four major types of gap patterns that traders seek to identify including breakaway gaps, exhaustion gaps, common gaps, and continuation gaps. Each has their own specific setup and contains a different set of risk-reward characteristics. Today we will take a closer look at breakaway gaps and exhaustion gaps.
Breakaway gaps, as they imply from the title, are a runaway movement in prices that typically signals momentum and volume moving distinctly in one direction. A gap to the upside will likely see continued upwards momentum whereas a gap lower will expose the opposite situation. From a swing trading perspective, this situation offers the opportunity to get involved in a momentum trade near the beginning while providing a multi-day opportunity for reward. It can also reflect the beginning of a new phase of a trend, hence greater reward for traders that get involved in breakaway gaps early.
From a strategy perspective, identifying areas to set entry and exit can be defined according to the gap price. For an upside gap, entry should be as close to the beginning of the gap as possible with exit planned for the price before the gap higher. Any move below the pre-gap price could indicate an exhaustion gap, not a breakaway gap which means a reversal strategy might be more useful and relevant for trading the gap.
A recent example of a breakaway gap would be USDJPY which has since gained substantially after breaking higher following commentary from the Bank of Japan regarding expanded quantitative easing and asset purchases. Since the breakaway gap, the pair has appreciated over 250 pips.
Exhaustion gaps, as the name suggests, is when a momentum move sees its last gasp in one direction before momentum reverses and the instrument either corrects or trends in the direction opposite the gap. A gap upwards that fades to the downside is typically viewed with a bearish bias while a gap downwards that fades upwards is considered to have a bullish bias. These situations typically occur towards the end of a trend and implies that an instrument’s direction has been overextended and is likely to see a pullback for deeper correction.
The best strategy for trading an exhaustion gap is first confirming that the trend has been exhausted and is in the process of reversing. This can be confirmed if the gap is filled in and continues to trend in the opposite direction of the gap. The best entry point to a changing trend is one that sufficiently confirms the reversal of the prevailing trend.
A recent example of an exhaustion gap and reversal would be GBPAUD which has filled in the upside gap and is trending lower after making another attempt to breakout to new highs. The fill in of the gap is indicative of a possible entry point into a new downtrend after the confirmation. However, if the pair moves back higher above the post-gap price this trend reversal might be not holding and could have merely been a pullback to momentum.
Classifying the gap correctly is important to applying successful swing trading strategies to the right situation. Misidentification can result in poor risk-reward characteristics for a potential trade. Whenever getting involved in trend following strategies, timing is imperative. It is also important to identify the proper trading time horizon to avoid being shaken out of a trade opportunity. Although it can be difficult to walk away from a trade and let the situation play out, constant monitoring might cause a premature exit from the trade instead of patiently waiting for the pattern to complete.