Prevailing market prices reveal valuable information about the current conditions and whether they favor trading. As such, traders are always on the lookout for shifting prices as they seek to determine their entry and exit points while trading.
Market gapping and slippage are some of the common forms of price shifts in a market. As a newbie trader, you ought to understand the significance of both.
Also, how market gaps and slippage affect your trading strategy is crucial as well as the means through which you can gain an advantage from either market gaps or in the case of slim time-frame traders, slippage.
Market gaps are a common phenomenon in trading, and they usually result in sudden price changes. Traders use these openings to deduce a new trend or an existing one that is shifting. Slippage, on the other hand, is usually prevalent while trading for the short-term.
Despite their differences, traders need to learn how to identify gapping and market slippage. Doing so will help mitigate your account against losses in a deteriorating market.
From its name, market gaps refer to a sharp break in the prevailing price of an asset. Typically, the price may move up or down relative to the previous day’s figure. However, this price shift is unexpected following a period when trading didn’t take place.
The ‘gap’ points to a space in the price chart between the previous and current trading days. As market gaps occur when trading is not ongoing, they are evident during the weekends when markets are closed.
Gaps aren’t anticipated, and traders can capitalize on this new information to gauge the general market atmosphere and decide whether to trade the gap or not.
Gap trading is a risky affair but at the same time, yield substantial returns when traded wisely. This article will cover gap trading below.
All traders have come across stop-loss orders. They are useful tools used that guarantee your profits from any trade you participate in. Also, the orders protect your position from additional lossmaking in case of a downtrend in price. However, when operating on a stop-loss, the chances of market slippage occurring are high.
Slippage defines the difference between the initial price specified in your order and the final price at the close of trading. Usually, your stop-loss will close your position at a price closest to the order. However, as this desired figure is unattained, you will be compelled to close at a different rate.
High market volatility is one of the primary causes of market slippage, and most brokers opt to wait out until the price is right. High volatility is often marked by rapidly changing prices and hence the chances of slippage occurring being high. Additionally, in the instance of a substantial market order, slippage may come about if the market volume is inadequate to sustain the bid/ask spread.
Any difference in the projected and intended prices qualify as market slippage. The term can further be used to define either negative or positive slippage depending on the direction of price.
Market slippage is prevalent in all markets, including FX, stocks, futures, bonds etc.
How does slippage occur in the FX market
In the FX market, slippage is seen when a stop-loss is initiated and closes your trading position at a different point than what was initially intended in the order. The forex arena is characterized by high volatility and hence slippage is a common phenomenon.
When slippage occurs, your order will be executed at a different price from what you initially intended. This may then result in a loss or profit, depending on the nature of the slip.
Distinguishing market slippage and gapping
Both slippage and market gapping ultimately affect your closing price. During slippage, your intended closing price is missed, and you end up with either a higher or lower price for your position.
On the other hand, market gapping may cause you to entirely miss your stop-loss because the prices shifted instantly. Market gaps occur when trading has stopped.
When you leave an open trade overnight, you run the risk bypassing your stop-loss price since the market may re-open, and prices might have moved entirely through the night. Eventually, you will have to settle for a different price altogether or wait out the storm.
Day-traders are specifically keen on their trades and will close their trading positions once on close of business.
Classifying market gaps
1. Common gap
The common gap is filled faster than others and this may take a few days to materialize. Common gaps do not result from any major news event and are generally insignificant when analyzing the general market atmosphere.
Common gaps are frequent since they appear overnight. They are smaller and follow a regular trend hence the reason for their insignificance when analyzing the market.
Also, common gaps appear frequently when the price is ranging. As such, trading common gaps is not advised more so in the absence of other positive indications. The other types of gaps, however, provide better trading prospects.
2. Breakaway gap
Breakaway gaps contrast common gaps in that they indicate a significant price change that is out of sync with the current range. A breakaway gap is prominent when the price breaks above a support or resistance zone, more so those that were recognized in the trading range.
Unlike common gaps that hold little significance, breakaway gaps signal emerging trends and often confirm them. This gap may be seen on triangle, cup, and handle or wedge patterns. As such, you can establish a trend by looking at the position of the breakaway relative to these patterns.
Traders can rely on breakaway gaps to decide on a trade move more so considering the market volume. When the volume rises on a breakout gap, you can expect the trend to hold following the breakout. On the flip side, in the case of low volumes, the pattern won’t hold out for much longer
Failed breakouts arise when the price gap lies above the resistance or under the support zone and eventually drops to its original trading range.
3. Exhaustion gaps
These are seen at the end of a trend. Exhaustion gaps are prevalent after a significant price increase. The trading volume may then be substantial or diminished. Reduced volumes point to a few traders participating in the market further leading to a weakened trend.
Traders can expect a reversal in the market where trading volumes are considerably larger than during prior trading periods.
4. Continuation gaps
Also known as runaway gaps, these result from increased activity in the market. Continuation gaps are rather diminished and unable to sustain a trend.
Usually, traders follow the trends in the market. A favorable trend attracts more players and a runaway gap forms during an ongoing trend.
Continuation gaps point to a trend whose momentum is on the rise. Like breakaway gaps, continuation gaps are connected to increased volumes in the market.
Because there is a strong trend in place, as evidenced by the continuation gap, traders use this as an indication to continue holding their position in anticipation of a further increase in the value of an asset. Moreover, non-participants may use the continuation gaps as a signal to enter the market as the price is likely to continue in the same upward trend.
5. Island reversal gap
The last type of gap, needless to say, has a strong reversal signal. Eventually, traders are left at a loss because of deteriorating prices in the market.
In the island reversal type, the break happens along the trend, after which the price moves sideways. Following this, another gap forms in a different direction and at this point, there is no price reversal to the sideways price point.
Significance of Market Gaps
Market gaps point to a changing market environment, as evidenced by the sharp change in trading prices. Price changes are affected by a wide variety of factors and in the case of market gaps, these factors are mainly fundamental.
For example, overnight news events, especially when it is not anticipated ca cause sudden price shifts which will be evident once trading resumes. Also, when new information about the economy is released, the market re-adjusts and will reflect the prevailing reports as the markets open.
When the prices shift up, the market similarly gaps upwards. This goes to show that traders were unwilling to exit the market with the previous day’s price. The converse is true in the case of a market gapping downward. Unfavorable entry prices forced market players to postpone buying.
Market gaps can cause your stop-loss order to bypass, leading to undesirable prices. You therefore ought to be aware when the gaps might occur and prepare adequately.
Typically, once a gap occurs, the market tends to correct itself in the long-run. This corrective measure is known as ‘filling the gap.’ Traders can watch out for price reversals to take place to trade.
How to Take Advantage of Market Gaps While Trading
In a broad sense, market gaps do not invite trading, and traders know all too well to stay out of the market. Nevertheless, you can still benefit from these gaps albeit after following due process.
With a combination of both technical and fundamental indications, traders can predict whether a gap may appear on the next trading day. A potential gap will attract buyers hoping that liquidity remains on the lower end.
Regardless of the strategy, you intend to follow while trading gaps, there are a couple of factors every trader must consider before gap trading.
- Gaps that are filling up rarely stop. Typically, support and resistance are absent around the gap and their absence enables it to fill up.
- Make sure that you understand the different types of market gaps since each type holds a different market signal. In both exhaustion and continuation gaps, the price doesn’t move in unison. Therefore, you need to distinguish each gap to better decide the direction of your trade.
- Trading gaps is risky because of the fundamental factors at play. The future is rarely set in stone when trading gaps more so among retail traders. Institutional trading entities, however, may ride the wave as they control significant capital. In essence, patience is critical when trading gaps, and you are better off waiting for the price to break to enter the market.
- Volume is critical when you want to trade market gaps. Breakaway gaps are tied to substantial market volume and low volumes are a characteristic of continuation gaps.
Gap trading is risky mainly because of heightened market volatility and dissimilarly low liquidity. Before indulging in this trading strategy, you need to understand that it is a high-risk, high-reward endeavor. On the contrary, however, gap trading rewards are quick when traded correctly.
In a Nutshell
Gaps are a result of several factors, some of which are beyond the control of traders. Granted, you cannot be in control of what the market does. However, studying market behavior could prove useful while trading.
Market gaps and slippages are regular occurrences on the trading scene. Traders should have a proper understanding of both phenomena. Moreover, traders should also seek to understand the underlying factors that cause both gaps and slippages.
Trading volume is a vital indicator of the market’s health. You shouldn’t consider the instances of gaps solely, but also include volume in your analysis. Volume can validate your decision to enter or exit the market and forms an essential part of deconstructing market gaps.
A large number of market gaps are fueled by irrationality in the market. Some people hold the opinion that trading is filled with emotions and rightly so. Global events can trigger drastic price shifts that eventually result in market gaps and slippages. Knowing the effect of such fundamental information will go a long way in mitigating against lossmaking trades.
Finally, learn to be patient. Market corrections occur after market gaps as they get filled. However, the time needed for this to happen is mostly unknown and it would be wise to wait for the rally to exhaust itself.