Should We Be Worried About Price Gaps?
Gaps are a common and a frequent occurrence in the market. This video explains what they are and why they happen.
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We have a quick question from Kerrick, actually referring to a trade idea that we were looking at on the GBPUSD today, and in this situation, we were looking for a buying opportunity on the GBPUSD, but we were waiting for a potential pullback to a key level to engage, but we did have a price gap to the upside over the weekend as good Brexit news saw some support for the GBP, and Kerrick’s question is whether we are worried about the gap being filled?
I think we can chat about this in a more general sense as well because gaps are a common and frequent occurrence. So, let’s start with what exactly gaps are. A gap you see in the chart is essentially just the difference between the closing price of one candle and the opening price of the next, and the gap is created when the price fluctuates enough between those two candles so that it creates a gap.
Price gaps occur on many different time frames, it can happen from one minute to the next or it can happen overnight, or it can happen over the weekend when the market is closed, and the market receives news information and sentiment causes the market to gap higher or lower at the open.
So, these gaps can occurred during trading hours when the liquidity isn’t great, like on any 1-minute timeframe you’ll spot a couple of gaps, or it might occur in stocks for example where you see gaps quite frequently as the open price on the next trading day fluctuates from the prior day’s close, whether that’s due to a change in sentiment or news hitting the wires or just down to the ebbs and flows, and then of course, as is the case with the GBP today, we had the positive news over the weekend of talks being extended which meant Pound gapped up at the open.
So, to your question, should we be worried about the gaps? It really depends on the sentiment. There is a lot of schools of thought in the trading community that usually says things like “every gap needs to be filled” or “the gap can’t go unfilled”, but it’s important to realise that there isn’t any rule that says the market has to fill a price gap. There was actually a study done that I read a while ago I can’t remember the website but I’ll search for it and let you know when I find it, but in this study they examined something like 20 or 25 years of price data on the S&P, and found that for every gap above 0.5%, the gap was only filled about 40% of the time on the current or the next day, and for all the gaps above 1.0% I think the number was something like 30%, which showed that it’s not as common a reaction as some market participants claim.
I think what often happens in those circumstances is confirmation bias. They see a gap and they see price move to fill the gap, and they link the price move to the gap fill, when the price move had nothing to do with the gap and everything to do with the sentiment. Because we are programmed to think in terms of patterns, it’s quite easy for traders to assume confluence or correlation means causation but that’s not the case. The fact that the market filled the gap and the reason why the price moved to the fill the gap is not the same.
Also keep in mind that a gap that occurs in line with the overall sentiment or bias for an asset is a positive sign for a potential continuation of the current trend to continue, but of course in certain circumstances a gap can create a great opportunity to use for fading a move that you know has gotten ahead of itself and using the gap as a trade target as the gap is filled.
So, to turn it into a practical example for today with the GBP, will I worry about the gap for the GBP? Not really. I still like the 1.33 regardless of the gap, the real thing I’m watching is whether sentiment on the Dollar on the GBP changes throughout the day, if that happens and we reach back or break below the 1.33 I’ll just re-evaluate to make sure I’m still trading in line with the current sentiment.
But, in line with those stats I mentioned earlier, let’s just for practicality’s sake use the 40% for the S&P, this was quite a sizeable move so let’s say there is a roughly 30% change that the gap is eventually filled, might not be today or tomorrow or maybe the day after that, but according to that nothing stops us from anchoring our stops behind areas like this or using these areas as potential profit targets to the downside, because we know there is a big part of the trading community that will be looking at that exact same gap.
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