Mind the gap: a strategy for trading a gap at the market open

So following on from the farce that is the Greek referendum and the political ping pong we seem to be intent on playing across Euro, I thought it might be nice to review market opens and gaps.

There are two things I want to cover here. The first is how to find out the market open prices, and the second is how to trade gaps.

So first thing, finding the market open price. There’s an easy answer for this, get yourself a data feed that provides quote prices. Typically you can start to receive quotes from as early as 5pm GMT on a Sunday (when the New Zealand markets open). These will give you an idea of the opening orders being placed into ECNs prior to the market open. If you have Metastock Xenith then it is really easy. Simply pull up a quote box like this one.

EURUSD at open

This tells me what the current Bid is and the current Ask, and who is providing it. In this case top of the book is HSBC with a bid of 1.0973 and an ask of 1.0978 and they provided that quote out of London at 19:31 GMT on Sunday the 5th July.

The second is how to trade gaps. Now this, as you can imagine, is a little trickier.

So typically you will hear a lot of people say that the FX market always closes the gap. Well the truth, if you look back over about 20 years of data is that this isn’t true. We have actually looked at it ourselves and simply following the rules of trading to close the gap isn’t actually that simple from an algorithmic stand point. But as a manual trader, it is surprisingly simple and that is typically because you can get a bit more information to make you life easy.

I am going to try and explain this using the EURUSD chart from the open last night, when we gapped lower due to the Greek referendum.

So for now ignore the volume profile information on the right hand side of my screen as I write this at 8am.

$EURUSD (30 Min) 06_07_2015

What we know at the open, given we have our quote above, is that the market is going to gap lower. We can then, using our volume profile chart, plot where the previous key resistance zones will be when the market opens.

In the chart above, I used previous areas where we saw a lot of orders and simply marked them with blue boxes.

Now we know as the market has opened and gapped lower it will have cleared out a fair few orders on the way down. Essentially we will have a relatively clean order book between the Friday close and the open price until people start re-entering orders.

This typically means the first test will be to retrace towards the close price on Friday to at least the first previous resistance point (as we gapped lower that is above, if we had gapped higher it would be lower).

So in this instance we make that in the first two hours of trading. The key then is to look at price action around this point and if we find orders to support the gap close.

In this case we get a strong rejection of a move lower and we start to see our volume profile indicator print a series of orders. This means the most likely move now is to test the next rejection level higher and therefore we can play a long trade.

$EURUSD (30 Min) 06_07_2015 2

This initial rejection is likely to be towards the low/high of the Friday bar depending on whether you gapped higher or lower at the open. If you gapped lower at the open, chances are your next resistance point will be the low of Friday’s bar, and if you gapped higher at the open the next support level is likely to be the high of Friday’s bar (this may or may not be the close).

This gives you your trade and gives you the highest chance of being successful attempting to try and close the gap.

Potentially the pair may then attempt to close the difference between that resistance point and the close price on Friday, but chances are if you are running into a weekend with a risk event that can cause the market to gap, then the close on Friday was really light volume and so isn’t typically worth the risk of the trade. In which case we would move stops up aggressively if we though the momentum was with us.