Trading gaps has long been touted as a profitable strategy in various markets. Most commonly we probably see gaps in the stock markets, when a stock that has seen overnight news, opens at a higher or lower level than the previous close. So in forex markets that happens on Mondays or after a long weekend etc. Depending on the exchange and the exact hours it operates.

The theory is that price will ‘revert to the mean’, and hence there is a higher probability of the gap closing, then carrying on in the direction of the gap.

A study by Caporale and Plastun, suggests that there is, in fact, an edge to be had in forex by trading market gaps. The authors examined data from 2000-2015 and focused on the GBP/USD and EUR/USD. Two of the largest and most liquid pairs.

Gap Study

Both the GBP/USD and the EUR/USD showed a profit by trading gaps over a 16 year period. However, the interesting take away from the study was that not all sized gaps were profitable.

Generally speaking, a smaller gap will occur far more frequently than a large gap. The authors of the study found that in the GBP/USD a gap size of 0.1% was most effective. While in the EUR/USD, a gap size of 0.05% was best.

There are of course two strategies you can use with gaps. You can sell a positive gap. Or buy a negative gap.

The study finds that selling a positive gap is best. And if you do, you will find a winning trade 60% of the time.

Over the course of the study period, 13 out of 16 years were profitable in the EUR/USD and 14 out of 16 years in the GBP/USD.

So there is quite a bit of data here to suggest that we can find an edge if we use gaps.

Using this Information

When I find an edge like this, I don’t necessarily want to blindingly apply it. We can use this knowledge with our own trading nouse to help find better entries.

We now know that if the GBP/USD gaps up by more than 0.1%, then we have a good spot to be short and know that 60% of the time, price will revert back to the previous close.

This is not a perfect strategy by any stretch, but often in trading, we are simply looking for a strategy that is better than a 50/50 proposition. And this one appears to be.