Trading on financial markets is always accompanied by constant dynamics, and we may only attempt to account for it by conducting an in-depth analysis. If we assume that assets are available for trading round the clock and fundamental factors may affect them only during trading hours, we may expect the charts to be consistent. In reality, most of the assets close for weekends and fundamental factors may happen at any moment in time, thus occasionally resulting in gaps.
Chart types and gaps
You may have already noticed these gaps in the form of empty spaces occurring on the vertical axis between two neighboring candles or bars. Gap price activity can be spotted on bar and candlestick charts, however, will not be seen on other chart types. Simple line and area charts are formed continuously connecting all of the points, while Heikin-Ashi charts smooth out the price movement for any two neighboring candles, thus eliminating gaps.
Gaps on the 1D Volvo price chart
Gaps give an idea of market sentiment
Gaps are important as they can give you an idea of market sentiment. When a market gaps up, that means there were zero traders willing to sell at the levels of the gap. When a market gaps down, it means there were zero traders willing to buy at the levels of the gap. This fact alone can tell a lot to a trader who follows the market sentiment.
Why do they form?
Commonly gaps can be found when markets open for a new trading session. You may observe it more often for assets with shorter trading hours, such as stocks. Stocks are available for trading while the corresponding stock exchanges are open (usually no longer than 8 hours per day, 5 days a week). When the stock is closed for trading, investors’ sentiments towards it may get influenced by a fundamental factor, which will be reflected on the chart only the next trading day. In this case, a gap can occur before the first candle of the new trading session is formed.
Gaps also happen on the Forex market, but for different reasons
Another possible reason for gaps to appear may be a substantial discrepancy between BUY and SELL orders. In such circumstances, an abundant number of bulls (investors, placing Buy orders) would buy out quickly all the bears’ (on the contrary — sellers) orders, creating a lack of liquidity and increasing the spread, hence forming conditions for gaps. Such a situation is uncommon to Forex, where you generally will not observe a lack of liquidity and where gaps are not very common on an intraday scale.
“So how do I use them?”
The four main types of gaps are: breakaway, exhaustion, common and continuation. Each has the same structure and differs only in its location on the trend. There are several common techniques suggesting how gaps can be used in trading. Some say that gaps will fill, meaning the price will move back and cover at least the empty trading space. Still, before you enter a trade on these grounds, keep in mind that it doesn’t always happen and a gap can take a month of Sundays to fill. It is fair to say, gap trading is rather risky and hardly predictable due to low liquidity and volatility. For this matter, it may be wiser to a stay out of the market after the gap has formed waiting for it to stabilize.
