Gaps in Technical Analysis

In the foreign exchange market, a gap occurs when there is a significant difference between the closing price of one trading session and the opening price of the next trading session. A gap can occur in either direction, up or down.

There are two types of gaps that can occur in the foreign exchange market:

Common Gaps: Common gaps occur frequently in the foreign exchange market and are not usually considered significant. They can occur due to normal market fluctuations or changes in sentiment. Common gaps tend to get filled, meaning that the price eventually moves back to the level it was at before the gap occurred.

Breakaway Gaps: Breakaway gaps are significant gaps that occur at the beginning of a new trend. They are typically associated with news events or changes in market sentiment. Breakaway gaps tend to be large and are not usually filled quickly. These gaps can signal the beginning of a new trend in the direction of the gap.

It’s important to note that gaps can occur in any market, and they are not unique to the foreign exchange market. Traders often use gaps as a technical analysis tool to identify potential trend reversals or continuations. However, traders should be cautious when trading gaps as they can be volatile and lead to significant losses if not managed properly.

Signals for Breakaway Gaps

A breakaway gap provides the price direction.
There is no price objective.
Increasing demand for a currency ensures a solid move on good volume in the foreseeable future.

Runaway Gaps

From a technical point of view, runaway, or measurement, gaps are special gaps that occur within solid trends. They are known as measurement gaps because they tend to occur about midway through the life of a trend. Thus, if you measure the total range of the previous trend and extrapolate it from the measurement gap, you can identify the end of the trend and your price objective. Since the velocity of the move should be similar on both sides of the gap, you also have a time frame for the duration of the trend.

Trading Signals for Runaway Gaps

The runaway, or measurement, gap provides the direction of the market. As a continuation pattern, this type of gap confirms the health and the velocity of the trend.
Volume is good because traders like trends, and confirmed trends attract more optimism and capital.
This is the only type of gap that also provides a price objective and a time frame. These characteristics are also useful for developing hedging strategies.

Exhaustion Gaps

Exhaustion gaps may occur at the top or bottom of a formation when trends change direction in an atypically quick manner. There is no consolidation next to the broken trend line: The trend reversal is very sharp through a bullish move, looks a lot like a measurement gap. So traders buy the currency and stay long overnight on that assumption. The following day the market opens below the previous low, generating a second gap. If the second gap is filled or does not even occur, the trading signal remains the same. Traders do not have to get caught badly in this exhaustion gap. A sudden trend reversal is unlikely to occur in an information void. Some sort of identifiable event triggers the move—maybe a government fall or a massive and well-timed central bank intervention. Therefore, traders should at least be warned.