Price Gap – Types and Formation
We will quickly discuss how price gaps are formed and how traders capitalize on these moves in the FX markets since we will witness this type of price action quite frequently especially when the market reacts to some important economic indicator, some breakout from a long sideways movement, or maybe a reaction to some political news.
Four Types of Price Gap
- The common gap – this is formed when the market is illiquid and is not very significant as these gaps tend to get filled easily
- The breakaway gap occurs when there is a breakout in either direction of a long phase of consolidation. These occur on heavy volumes and signal the start of a new trend. A large number of orders are usually placed on either side of a consolidation so that if a breakout occurs these orders would be fulfilled. Take the case of USDJPY, its been consolidating for a while and it’s difficult to judge the direction of the breakout. A trader could, however, take a position on the Yen in whichever direction it breaks by placing a stop loss order. For example, if a trader wishes to capitalize on the breakout in USDJPY he could place a buy stop-loss order at say 111.50 or a sell stop-loss order at 110.80. The S/L order would only trigger if the Yen breaks out in either direction. If many stops are placed at these levels you could see a price gap called the breakaway gap
- The runaway or measuring gap is when prices are already jumping higher and somewhere around the midway point start to gap again. Take the case of traders who have huge unfilled positions or traders waiting to initiate their positions as they might have missed the move. These traders are now waiting on the sidelines praying for a retracement of some magnitude, even 33%. However, despite waiting for a while they see prices moving only north and their nerves give way. They now start buying at whatever price they can to fulfill these orders or long positions. Market makers see this buying frenzy and start trending the price much higher. If the market maker quotes 112.20-23 and gets taken at 23 the next price he might quote is 27-29 depending on how many calls heâ€™s getting and how many takers are taking his ask side.
- The exhaustion gap – when most of the orders have been filled and the market is still pushing higher, the distributors look to start selling. They see a strong resistance point approaching, see momentum indicators as unsustainable, and may see a final price gap called the exhaustion gap, which fills up when prices start falling. This filling of the gap signals a move all the way to the initial breakout point.
You can watch the free video training on price gaps here
Next, we will take a look at trend reversals and how to capitalize on those.