Trading Gaps in Forex... Is there even an Inefficiency Present ?

A few days ago I came across a thread in forex factory (here) which discussed the trading of "gaps" in the forex market which occur every Sunday because of the inherent movements that are present on the weekends but unwatched by the majority of forex brokers (forex is truly a 24/7 market). Unlike in the stock market, these gaps appear only once each week, when the market opens for most people on Sunday afternoon (EST). Trading gap closes (aiming for price to "close the gap") is actually a commonly suggested trading tactic in stocks so I started to wonder if there was a market inefficiency that could be exploited in forex trading in relationship with the Sunday gaps.
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For me the approach the people at forex factory were taking to tackle the problem is wrong in some aspects. First of all, you cannot use a fixed SL since the value of the gap is very variable and changes with market conditions. Using a fixed amount of pips is simply wrong and will inevitably lead to loses once market conditions start to change and the gap sizes become much wider/shorter. The actual trading solution seems simple, aim for the close of the gap as your take profit value, use a multiple of the gap as your SL and use the gap to calculate lot sizes so that the amount you risk becomes fairly constant (risk less with higher gaps, risk more with shorter gaps).For practical purposes, you will also need to have a SL and TP of minimum 15 pips since this number is the actual minimal limit for SL and TP placement on many brokers.

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I decided to give it a shot and code a simple EA to trade this technique. As you see on the next image, the EA enters trades in the direction to close the gap and assigns the TP and SL both as the gap size. Lot size is also adjusted against the gap size so that the amount of money risked per trade becomes independent of the gap size of any specific trade.
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The image above shows the backtesting of this strategy from Jan 01 2000 to Nov 01 2009 (EUR/USD). As you can see, the strategy is break even in the long term with many profitable and unprofitable periods. Also note that profitability may be in fact overestimated due to one minute interpolation errors on some trades (due to some trades having a TP and SL of 15-20 pips). There are only 178 trades in 9 years, something that indicates that only 38% of the Sunday gaps are larger than 15 pips while the majority are smaller than this (therefore if all gaps were traded SL and TP orders ccouldn't be placed on many brokers, also accurate simulation would become problematic). Gap sizes also vary greatly and are independent of general market volatility with large gap sizes happening on both highly volatile and low volatility markets. However the largest gap sizes did happen during the market crisis in 2008 when volatility was extremely high.

So does an inefficiency exist ? It is hard to say. The tests reveal that only on 51% of the time the gap is closed before advancing at least one gap size away from the entry price (hiting the SL), this means that statistically it is almost identical to entering a trade on a coin toss at Sunday open and using the gap size as a mean to exit and manage the trade. However most of you may now be thinking, can the odds be improved ? Can we modify the SL, TP, etc to afford a more profitable strategy ? Well, the answer is that yes, you can actually play a little bit with the settings and increase the odds. A full optimization of the EA reveals that you can hardly get results higher than a 0.5% average yearly profit for each 10% draw down. Taking into account the probable interpolation errors, I would have to say that there is simply no inefficiency related to gap trading. There seems to be no statistically favored outcome when the market faces a gap, it may close it before reaching the SL (up to 6 times the gap), or it may not. Running a statistical ANOVA analysis you will find that there is no correlation between gaps and movements that end in closing. The system is as good as picking a constant bar each Monday and entering a trade on the next bar assuming that price will return to the open of the previous bar.
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So is the strategy profitable ? Well, you might get lucky and catch a period in which loses rarely occur like late 2009 or late 2007 however you will eventually give back almost all your profits and come back to where you started. It seems that if you a use gap adjusted technique you may just be break even in the long run. If you run this strategy without adjusting lost sizes, SL and TP to the gap size you will wipe your account (in the long term) due to the higher loses under varied market conditions. In conclusion, price does not react to gaps in a statistically signficant manner, either in one way or another. Gap closing is not an inherent characteristic of the market.

If you would like to learn more about profitable system design and how you too can start your journey to achieve long term stable profits in the forex market using automated trading solutions please consider buying my ebook on automated trading or subscribing to my weekly newsletter to receive updates and check the live and demo accounts I am running with several expert advisors. I hope you enjoyed the article !

My Sorry Excuse for a Trading Journal...

For those of you who have followed my posts on manual support and resistance trading and who were excited with my manual trading journal I have to say : I am sorry. Certainly I had made an effort to put up the file on the FTP and to trade the system manually so that you could all see what I do to trade these S&R levels but certainly I may have disappointed a few people with the lack of description and the overall lack of discipline in which I addressed this journal at first. Truth be told, I have been terribly busy with my other trading duties and getting all the journal stuff done with all the analysis required would have taken me a lot of time I did not have in my hands.

To top that off, I started with a trade on the GBP/USD which I never even finished analyzing. After that I also did not open other trades on that account which I did trade on live accounts. Why ? Well, sadly the facts of life didn't help and I had to format the computer that carried the mt4 instance in which I had the demo account used for the S&R trading so unluckily for me I lost access to that account and therefore I could not place any other trades. I know that some of you are faithful to my website and in no way have I intended to waste your time. If you have visited my website for a while you should know that I always handle my projects seriously and tend to the needs and profitability of my visitors and customers.

Well I sure made a commitment to write a good manual trading journal and I certainly intend to do so. From now on the demo account of the trading journal will be VPS hosted to avoid any computer problems and I intend to write a small note on the journal every Monday as to why I traded or did not trade that week with a detailed explanation of each trade as I had explained before. Obviously the first trade I made will remain on the journal and I will finish its analysis so that we may start with a finished trade. So I invite you to check the trading journal file every week on the ftp and to check the account statement on the lower part of the left hand sidebar. I of course give you my word that it will be kept updated and that we will certainly learn a lot about S&R trading from it.

Again, for all of those who have been looking at a journal file that was not updated, I am sorry, but from now on the journal will be one of my primary concerns related to the website. However if you would like to learn about automated trading system and what can be done to design profitable one please consider buying my ebook on automated trading or subscribing to my weekly newsletter to receive updates and check the live and demo accounts I am running with several expert advisors. I hope you enjoyed the article !

Forex Strategies : Trading Dynamically for Success, a Trading Strategy for Successful Manual Trading

After being in the foreign exchange game for several years, I have seen how desperate and misled people are when they go and search for a manual trading system they can use to succeed. In general, you always find website that offer general advice but fail to accurately portray the trading system or you find websites that suggest the use of a given set of trading signals with no reference whatsoever to any money management technique.

As you may know, any successful trading strategy must have entry rules, exit rules and adequate money management. As I have said on a recent post, money management must take into account you risk level, your equity and the current state of the market. Of course, the entry and exit of a manual trading strategy should also adapt to different market conditions, contrary to an automated trading system, manual trading has the advantage of trader discretion which can be exploited positively to maximize returns when compared to any given fully mechanical set of rules.

What I am going to describe now is one of the systems I use to trade the forex market manually. This system does not have very rigid rules and is therefore dependent on the traders knowledge of the market to succeed. However, I believe that trading manually always demands this, doing anything different would just reduce your manual trading to the level of a machine, something for which we have automated trading systems. One very important aspect of this foreign exchange trading system is that the money management is very clearly defined. Since this is the most important aspect of trading, it will most likely bring good profits to forex traders.

The system is very simple and uses no indicators whatsoever. What we will do is trade support and resistance levels (I do this on the EUR/USD daily chart). What I do is pretty simple, when a support or resistance level is reached, I place two pending orders around the level, located at a distance of 25% of the previous daily bar away from the level. One order will favor a breakout and the other will favor a reversal. Now, after we have an order triggered I will set the stop loss and take profit so that I have a 1:3 risk to reward ratio on the trade using the next historically important support or resistance level as takeprofit (note that the stoploss must be below the inital resistance or support level or I will not take the trade, because of the risk of a retest). The lot size traded will be such that if the stop loss is hit a loss of 2% of equity is incurred. This system ensures that both lot size, TP and SL are adjusted dynamically and always keeps the trader at a very favorable 1:3 risk to reward ratio which is the level of risk most proffesional traders are willing to take. The daily resistance and support levels work like a charm and the strategy will give you overall profits if your discretion about these levels is accurate.

Of course, as you see, the location of the support and resistance levels and the placing of the take profit is completely discretionary so the trader should be familiarized with how these levels work. Most traders will have no problem visualizing these levels after a year or so of looking at currency pair charts. Similar simple trading techniques based on discretionary trading of support and resistance levels are used by several successful proffesional traders and fund managers around the world. It is a powerful technique and removes fear and greed from trading as it encompases solid trading principles. Remember that fear and greed are no more than the manifestation of ignorance.

If you would like to learn more about the automated trading systems I have developed and how you too can design, program and trade long term profitable systems on the foreign exchange market please consider buying my ebook on automated trading or subscribing to my weekly newsletter to receive updates and check the live and demo accounts I am running with several expert advisors. I hope you enjoyed the article !