Effective Gap Trading in Forex

MASTERING THE TRICKY HOLES

“Chance only favors prepared minds”. - Louis Pasteur

Hello:

Peter Soodt, Scott Andrews and Eric Waddell are skillful gap traders; though in other types of the financial markets. One thing the human brain can do - in addition to myriads of awesome achievements made by it – is that wealth can be built by it regardless of the uncertainties of the future. Necessity will forever be the mother of invention. The unpredictability and uncertainties of the financial markets have led to the development of some permanently successful trading strategies. Here lies before you a profitable trading strategy for swing traders, used in managing trading portfolios, and of course resulting in decent profits on annual basis: something you’ve been dreaming of.

Nature of Gaps and Market Participation

A gap is defined as a price level on a chart where no trading occurred. These can occur in all time frames but, for the purpose of this Forex gap trading strategy, we’re mostly concerned with hourly charts. A gap on a chart happens when the market closes at one price but opens the following day at a different price. Why would this happen? This happens because ‘buy’ or ‘sell’ orders (usually caused by pre-market events), are placed before the open that cause the price to open higher or lower than the Friday's close. Normally, the most common time to see gaps occur are over times where a specific market is not being traded, like stock market overnight and Forex market over the weekend. There are breakaway gaps which happen as breakouts in a sideways price movement, continuation gaps (also runaway gaps) which occur during strongly trending market and exhaustion gaps that happen at the end of primary trends – thus signaling the beginning of a noteworthy reversal.

Since gaps are generally caused by market participants, it’s important to know if the price movement is caused by novices who make impulsive orders or by experts who make rational and logical decisions. The trading masses will always leave their trail on the price chart. In order to comprehend this concept better, you must bear it in mind that experts would like to sell when the investing public feels it’s clearly time to buy: they buy when the investing public thinks the market is clearly southbound. Amateur traders do exactly the opposite of what professional traders do. Amateurs would buy only after some have bought and made money and vice versa; just when pros are preparing to take opposite directions. But little did they know that when the market sentiment is overly bearish or bullish, a strong reversal is imminent.

For this strategy, if the market gaps up after a wave of buying has already occurred, it shows what amateurs are doing. If the market gaps down after a wave of selling has already occurred, it also shows what amateurs are doing at that moment. Therefore there are clear steps a professional trader should take. Gaps can provide nice swing trading profits but trading them requires some expertise – especially in terms of entries and exits. The advantage is that you can sometimes make big profits, quickly, and with a measure to limit risk if things go wrong. This is something each Forex trader should take advantage of.

Signals Filter Rules

Price action and the Williams’ Percentage Range are used to generate signals on hourly charts (to avoid too many or too scanty signals). Based on past experiences, a gap that forms on MT4 from one reliable broker must also be visible on MT4 from another reliable broker. For example, I consider a signal only if the gap on the MT4 from Alpari UK also appears on the MT4 from FXOpen. Otherwise the signal would be disregarded. Besides, a gap trade isn’t immediately taken when entry criteria are met; I wait until the close of the New York Session. If a gap occurs from a price action, it’s taken only after the William’s % Range goes into the overbought or the oversold region within 24 hours, relative to whether I’m planning to buy or sell. In addition, if the number of signals is less than 3, no positions would be assumed for that week unless there are mid-week gaps (rare occurrences).

Position Sizing Methods and Exit Techniques

The position size is typically 0.01 for each $1000, but 3 different exit techniques are devised:

Exit technique #1: A position is opened with a Stop of 100 pips and a target of 200 pips. This generates the biggest profit and the risk to reward stands at 1:2.

Exit technique #2: Two positions are opened per signal with 0.01 lots for each $1000. The Stop for both trades is 100 pips each, while the target for the first trade is 50 pips and the target for the second trade is 200 pips. This has the second biggest profit and drawdowns are tolerable just like the other 2 exit techniques. This is the technique assumed for our real live accounts.

Exit technique #3: A position is opened with a Stop of 100 and a target of 50 pips. The purpose is to take advantage of short-term movements in our directions. The risk to reward stands at 2:1. The profits are smaller than the other 2 exit techniques, yet it makes nice profits because of a higher long-term hit rate.

Application of Risk Control and Further Trade Management

Predicting short-term moves is much easier than predicting the longer term. Unfortunately, the real money is in capturing longer-term trends. Therefore, I look to capture a small, quick profit but keep a portion of the position as long as the market continues to move in my favor. This allows me to ‘eat my cake and have it too.’ The risk stands only slightly below one as compared to the reward, but it has the advantage of reducing the potential risk per trade by almost 50% if the price moves by over 50 pips before reversing to hit the Stop. Once again, the exit technique #2 has been chosen for signals generation and on live accounts (which doesn’t mean that other techniques are ineffectual). When 2 orders are opened for a signal, and they move very well in the forecasted direction, the 50-pip target would be hit. Then if the market goes on by 70 pips and above, the Stop is moved to breakeven to eliminate the risk on the remaining trade. If the 200-pip target is reached before Friday, good; but if not, the position is smoothed at the close of the New York Session that Friday.

A Trade Example

There’s a need to show some examples of trades taken with this strategy, but I can only mention one example owing to time and other responsibilities. I’d show further trade examples in my future articles. Please check the accompanying chart. There was a gap down on the EURCHF at one opening of the market and an opportunity to buy emerged when a demand zone was identified. This was a zone where there were more willing buyers than sellers, plus further confirmation was made when the William % Range went to the oversold region. The vertical line on the left show where the trade was opened, while the vertical line on the right shows where it was smoothed. This signal was effective.

Order: Buy

Entry date: January 3, 2011

Entry price: 1.2438

Stop Loss: 1.2338

Exit date: January 4, 2011

Exit price: 1.2638

Status: Closed

First profit target: 50 pips

Second profit target: 200 pips

When Things Go Wrong

Gaps are often filled, but sometimes they mayn’t be filled. Because this strategy anticipates that a gap would be filled, the only thing that can go wrong is when a gap isn’t filled and I’m on a wrong side of a trade. Stop Loss limit helps, but since we’re not 100% sure whether or not a particular gap would be filled, the strategy trades each valid signal until there’s a winning trade. But that’s part of the statistical win-loss ratio one needs to accept right up front. Bad days will happen. But I believe in the statistics that says my strategy will recover. One doesn’t need to get too upset. Even professional poker players lose a game now and then. The worst thing to do is over-react and stop trading after just one bad day or week.

Take Charge of Your Fate on the Markets

Great ideas don’t become reality because some don’t spend the time, effort and resources to make them happen. Taking advantage of the gap trading strategy discussed here can bring about your long-term survival on the markets – something you’ve been dreaming of. Here too, we’re not afraid of losses, for we know we’ll make more money than we lose (the secret of survival) in the long run. You might want to take advantage of this trading methodology by getting access to an account on which I use it, so that you may trade accordingly. The access can be gotten here: http://www.fxinstructor.com/en/analytics/ituglobal

NB: While more successful examples of gap trading would been analyzed in future, another effective Forex strategy is coming within the next several weeks – all for the benefit of my clients.

This article is ended with a quote from Eric Waddell:

“You are not infallible… Even if there is 90% chance of a trade working out, there is a 10% chance it will not. It is that 10% which prompts me to place a stop and realize that I am not infallible and it may in fact go against me. Which is fine, it is all part of trading.”

Your questions and opinions are highly welcome.

Thank you.

With best regards,

Azeez Mustapha

Forex Signals Strategist, Funds Manager &Coach

Senior Analyst

FX Instructor, LLC

Email: amustapha@fxinstructor.com

Yahoo! Messenger ID: saazalmu

Are you facing any challenges in trading? You might want to explore the secrets of markets wizards and duplicate their success. Get the secrets from my past articles at:

www.fxinstructor.com/blog/author/amustapha

www.fxinstructor.com/blog

Get my Forex trading signals at: http://www.fxinstructor.com/en/analytics/ituglobal

And my past articles are also available at: www.ituglobalforex.blogspot.com

NB: There is risk of loss in trading, but it is possible to be a successful trader.