Algorithmic and Mechanical Forex Strategies | OneStepRemoved

The Advantages Of Forex Over Stock Trading

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Some traders arrive at forex after first trading stocks, or perhaps investing in bonds. Others discover forex trading before they’ve experienced any other kind of investment. In any case, forex offers plenty of advantages over trading stocks and other sorts of investments.

Most independent traders begin their careers by reading basic books about personal finance, plus various “how-to” books about specific trading niches and money-management techniques.

Some traders are fortunate enough to have professional mentoring or an exceptional “prop trading” opportunity. Yet, most traders begin on a small scale and with appropriate testing and “paper trading” before committing real money.

For those whose first trading experience is with stocks, forex offers plenty of benefits. Let’s have a look at the advantages of forex trading when compared with stock trading.

Comparing forex against stock trading

Most financial authors say that “conservative” stock investments should yield an average of around 5% annually, and “risky” investments in a diversified portfolio of stocks and mutual funds should yield somewhat higher. Of course, traditional wisdom says that the stock market rises an average of about 10% per year, over time.

Buying equities can be highly profitable. Yet, success in stock markets usually requires fundamental or “insider” knowledge about a specific company. Savvy investors must know their favorite stocks well enough to spot a bargain, and likewise be aware when their favorite funds are undervalued.

Independent investors in the stock markets soon discover that their timing is usually one step behind the big players in the market. Large investment funds are staffed by professional analysts tasked with studying all fundamental and technical information available about a particular company.

So, it’s usually quite difficult for small traders to earn more than a few percentage points in annual gains with stocks.

Worse, since few stock-fund money managers ever consistently achieve more than 20% in annual gains, probably very few retail investors could do better. But, instead of accepting ho-hum returns in the stock markets, investors have turned to forex trading instead.

Forex is better than stock trading

Forex trading offers plenty of advantages over stock trading –

Superior liquidity. With more than $2 trillion in transactions each day, forex offers the best liquidity. Buy and sell orders are filled instantly, which means less “slippage” and better profits.

“Paper trading” forex offers an accurate test. Many traders begin by first “paper trading” or mock trading a demo account. However, trading stocks in a demo account is far different from real trading, because of the delayed order execution times and reduced liquidity in real stock markets. So, beginners may fail through flawed strategies.

In contrast, because of the lightning-quick executions and deep liquidity in forex markets, “paper trading” in a forex demo is generally an accurate simulation of real-world results.

24-7 trading. Forex trading platforms are open 24 hours per day, five-and-a-half days per week. On the other hand, stocks are often illiquid after daytime trading sessions close.

Forex can’t be controlled by large players. Banks and financial institutions, investment funds and high-net-worth individuals can all influence the movements of stock prices, whether up or down. Unfortunately, major stock market players generally scoop up most of the price gains during such rises, and leave independent stock traders with most of the losses during price drops.

In contrast, the enormous volume in foreign currencies traded each day means that nobody, including central banks and heavyweight investors, could manipulate the forex market.

Leverage. Although leverage in stock accounts is typically limited to a ratio of 2:1, forex offers as much as 200:1 leverage.

No restrictions on selling short. Stock markets enforce an “uptick rule” so that short-sales must be entered when a stock’s price is moving upward. This negates most profit-making opportunities. On the other hand, forex positions can be entered either long or short, without restrictions.

The psychological advantage of forex over stocks and other investments

Because of the foreign exchange market’s global liquidity, traders can achieve far greater returns by using expert advisors (EA) and mechanical forex trading systems, while avoiding stock trading.

The biggest advantage of trading forex instead of stocks is a psychological one – In a world dominated by large financial institutions, forex can level the playing field for small traders.

Independent stock traders are forced to compete against professional fund managers and institutional investors with superior resources for fundamental research. Forex is different because it lets the trader control of his or her own fate.

Superior leverage gives traders the opportunity to earn far more from successful forex trading than from stock trading. In sharp contrast to the typical single-digit yearly gains in stock-trading accounts, forex offers the potential for much larger returns.

Have you traded stocks as well as forex? If so, how would you compare them?

Mathematical Expectation in Multicurrency Forex Trading

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Some forex traders use the same trading strategy for all currencies, while others use entirely different strategies depending on the currency pairs being traded. Or, traders may use multiple strategies with multiple forex pairs, in order to perhaps increase profits while reducing the risk of drawdown resulting from over-concentration on a single strategy.

Expert advisors (EA) make it possible to optimize the input parameters, yet they don’t necessarily make it easier to put separate strategies together into a single system. And, testing may show increased risk from overlapping or correlated drawdowns when disparate forex strategies are merged together.

Using algorithms, a trading system can check currency pairs and perform specific operations according to input parameters. A multicurrency, multi-system EA can be crafted in order to assess all trading strategies side-by-side. This may be helpful in case only a single EA is permitted to access a given account.

It can be challenging to develop a forex trading system that works well across different currency pairs under a variety of conditions. Most of the widely-known systems for multicurrency trading are based on trend-following strategies, such as Donchian-channel breakouts, and are designed to profit from very long-term trends. Yet, a multicurrency strategy must show clearly show a winning “edge” over the typical time horizons for forex traders.

Mathematical expectation forex strategy

For example, in order for a system to work well with both EUR/USD and USD/JPY the signals must have a high likelihood of success in spite of volatility and potential correlation between the two pairs. And, trades must become winners during fairly short time periods. If not, then trading correlated pairs may create a risk of over-concentration and excessive drawdown.

There are many profitable opportunities in trading the four major currency pairs — EUR/USD, GBP/USD, USD/JPY and USD/CHF. I’ve been enjoying good success by using a strategy based on Mathematical Expectation (ME). I use ME to analyze data and spot comprehensive trading opportunities and calculate entry/exit points for trading the four major currency pairs.

Mathematical expectation predicts the likelihood that a forex trade will win

A well-programmed EA can use ME tools to help build systems that work across multiple currency pairs. I’ve helped developed a couple of systems that work in real-time and show long-term profitability through back-testing.

Recently, traders have become more aware of the drawbacks that arise when using data-mining techniques to back-test and fine-tune strategies for forex trading systems. Alternative system-development methods like System Parameter Permutation (SPP) are now available and can help traders avoid the issue of data-mining bias.

If done carefully, SPP or data mining will help build a set of good-quality indicators to generate signals across the four major currency pairs. Then, the expert advisor calculates Mathematical Expectation to see whether the trade is likely to be profitable or not.

Finally, it’s a matter of specifying filters and testing to find precise strategies that consistently result in winning, profitable signals. Entry and exit points are calculated by the mechanical trading system using mathematical expectation adjusted for current volatility.

Calculating the mathematical expectation of success

Mathematical Expectation (ME) is a statistic that measures the greatest temporary profit that a trade experienced the entire time it remained open. It was first popularized under the Optimal-F position-sizing and money-management rules developed by Ralph Vince. The equation is:

Mathematical Expectation = MFE – MAE

The mathematical expectation tool gives multicurrency forex traders a predictive “edge” in developing winning systems. ME is defined according to the concepts of Maximum Favorable Excursion (MFE) and Maximum Adverse Excursion (MAE). ME’s value can be calculated in real time by the mechanical trading system.

Maximum Favorable Excursion is the greatest balance on a favorable trade before a forex trade is closed out, regardless of final closing price during the time period, whether daily, hourly or minutely. MFE is the highest positive balance achieved while the trade was open.

Maximum Adverse Excursion is the largest unrealized or temporary loss during a trade, regardless of whether the trade was closed out as a loser or not. MAE is the lowest negative balance on the trade while it was open.

In order to quantify and analyze the ME from a given forex pair, traders can simply calculate average MFE and average MAE for a large number of past trades. Mathematical Expectation equals Maximum Favorable Excursion minus Maximum Adverse Excursion.

If average MFE is larger than average MAE, then the Mathematical Expectation is positive. The larger the ratio between MFE and MAE for a given currency pair, the more favorable is the outlook for a potential trade.

Multicurrency forex trading strategies based on Mathematical Expectation

When trading EUR/USD, GBP/USD, USD/JPY and USD/CHF with a multicurrency strategy based on the Mathematical Expectation, this metric is usually positive and generally high, and similar among the various currency pairs.

It’s important to avoid evaluating position size, or trade-exit rules or any other parameters while the expert advisor analyzes the entry points. Those parameters can be set independently by the mechanical trading system based on ME adjusted for volatility, as discussed later in this article.

After determining the entry point and trade direction, the mechanical trading system calculates MFE and MAE values generally first at 10 bars beyond the entry price, then 15 bars beyond, then 20 bars beyond the entry price.

In addition to signaling entry points, the ME also shows whether the forex trade’s advantage is best immediately after opening the position, or at some average interval after being in the position.

My simplest multicurrency trading strategy uses daily charts and relies on a combination of three price-based rules, and only a few parameters that use mathematical expectation to predict success.

The rules for long and short trades are as follows:

Trade long (and close out a short trade) when:

Close > Previous Close
Open > Previous Low
Previous Close > Prior Close

Trade short (and close out a long trade) when:

Close < Previous Close
Open < Previous High
Previous Close < Prior Close

This system reverses the trade when the signal changes. So, if the system has a “long” position open when a “short” signal is received, the system will close the long position and instead go short. Likewise, if the system has an open “short” position when a “long” level is received, it will close the short and immediately go long.

Another parameter of this system is the stop-loss trigger which is set at a value just slightly more than the fifteen-day or twenty-day average true range (ATR). This value is updated each time a new signal is received in the same direction.

Nevertheless, if there are new signals in the same direction, my system does not add new positions, since I’ve found that drawdowns outweigh additional profits when doing so.

Finally, regarding position size the system allocates a maximum 2% of account equity to a single high-ME trade. If there are multiple signals in several currency pairs, yet the ME calculations are showing correlation among the signals, the total position sizes will be no more than 2% of equity.

Trading results

This simple multicurrency forex trading system has shown decent results in real trading, and back-testing over a twenty-year period shows that it would have enjoyed profitable results for at least sixteen out of the twenty years tested. It has shown a reward-to-risk ratio of about 1.7 and winner percentage around 45%, while the profit factor was nearly 1.4.

Still, the drawdowns can be lengthy – The longest drawdown seen under back-testing was more than 1000 days. The ratio of profit-to-drawdown when using this strategy is similar to that of buying-and-holding stocks, and during back-testing the ratio was about 0.35 with a total return of more than 500% during a twenty-year back-test.

Risk management for multicurrency trading strategies using ME

By knowing the average MFE and MAE values, a forex trader can program a multicurrency mechanical system to exit a trade at a profit target or stop-loss point determined by adding a calculated number of pips beyond the Maximum Favorable Excursion or Maximum Adverse Excursion values.

On average, in order to win over time the forex trading system must reach the profit goal more often than it touches the stop-loss exit level.

For example, if my system is seeing an average MAE of 35 pips and an average MFE of 55 pips, there is a tradable opportunity. The profit target may be projected for 50 pips, which is 5 pips less than MFE, and the stop-loss exit can be set at 30 pips, which is 5 pips beyond the MAE.

Regarding system design, it’s important to program the trading system to define profit targets and stop-loss points according to volatility instead of setting a fixed number of pips.

Volatility helps determine exit points for multicurrency trading

As mentioned earlier, a mechanical trading system can easily use Average True Range (ATR) as a volatility-dependent tool to calculate MAE and MFE in order to set exit points. The system determines the entry price plus or minus a percentage of the ATR that is workable according to the ME analysis. To have a large enough sample, I usually set the ATR to calculate the previous 15 or 20 time frames.

For example, during a market when the EUR/USD is moving an average of about 100 pips per day, the system should calculate target profit points and stop-loss points based on current volatility and the analysis of ME.

So, if a trade moves in a favorable direction for 55 pips, and if the current ATR is 85 pips, the move is not reported as 55 pips; instead, the MFE is reported as 64.7% of ATR.

Over time, I’ve seen that the MFE for the four major currency pairs EUR/USD, GBP/USD, USD/JPY and USD/CHF seem to fluctuate around an MFE value of about 60% of ATR, and average MAE around 40% of ATR for the typical entry after 15 time periods.

In order to fine-tune forex trading results according to volatility, the mechanical trading system can set the profit targets and stop-loss points at varying levels. For example, the system may set the profit target exit point at 55% of the ATR value away from the entry point, not at the MFE full value of 60%.

And, volatility may require setting the stop-loss exit points at 45% of ATR value beyond the entry point, not at 40% of ATR. Still, this system is likely to reach target profit levels more often than stop-loss levels, and winners should be larger as long as target profits are set larger than stop-losses.

For all trades, the calculated number of pips for target profits and stop-losses is always based on volatility just at the moment of the trade, as reflected by the ATR.

When a signal arises, the trading system checks the value of current ATR, then calculates the exact number of pips to reach target profit and stop-loss levels.

As an example, assume there is a signal to go long in EUR/USD,and the current ATR is at 100 pips. So, the target profit point will be at 55 pips over the entry price (55% of the ATR value). And, the stop-loss will be at 45 pips under the entry price (45% of the ATR).

A few more thoughts about Mathematical Expectation

The mathematical expectation is generally lower for “short” trades, and some traders have seen ME increase by as much as eighteen bars after the open, then decay during price swings by as much as eighty bars after open.

For “long” trades, the ME generally has a longer lifespan, with values that may increase quickly up to the thirtieth time period, and then continue slowly onward up to about 75 time periods. Using this system, my average trade duration is about 25 days.

The best upside when trading EUR/USD, GBP/USD, USD/JPY and USD/CHF seems to accrue by about 30 time periods. If the favorable movement continues onward past that average point, then it’s likely that some sort of fundamental bias in the market is prolonging the move.

In summary, this basic multicurrency forex trading strategy takes advantage of a positive, high ME shared across the four major currency pairs. The entries, profit targets and stop-loss points are all based on ME.

When the Mathematical Expectation indicators are predicting success, the four major currency pairs — EUR/USD, GBP/USD, USD/JPY and USD/CHF – can be successfully traded either together or separately.

Have you tried ME in your trading?

Fractals in Forex Trading

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Fractals indicate natural resistance and support levels, which helps to identify good entry points and locate stop-loss points. Most importantly, fractals help me identify trends and ranges.

Fractals can be used effectively in forex trading, especially with the power of a mechanical trading system. Focusing on the EUR/USD and GBP/USD currency pairs gives the best results.

A fractal is a repetitive natural pattern

A fractal is a geometric shape or set of self-similar mathematical patterns found in nature. When broken into smaller pieces, fractal shapes exhibit the same shape or characteristics of the larger object.

In nature, fractal shapes and patterns may be observed in things such as broccoli and many other types of plants, where the smallest florets still have the same overall shape as the largest “head” of broccoli. Likewise, many mineral and crystal forms exhibit similar patterns on both large and small scales.

Price movements in marketplaces are often thought to be random and chaotic. Yet, as with other seemingly-random forms found in nature, fractal patterns can be observed in price charts of forex pairs and other assets. Forex price movements show certain repetitive fractal patterns which can be profitably traded.

Fractals used in forex trading may show the same form at every size scale, or they may show nearly the same form at different scales. Stated simply, in forex trading a fractal is a detailed, self-similar pattern that repeats itself, often many times over.

It’s important to note that these fractal patterns aren’t the regular, geometrically-square figures found in man-made structures; they don’t have sides with even-integer factors. The distinguishing characteristic of fractals in forex trading and elsewhere is their natural organic scaling when contrasted with ordinary geometric figures.

For example, doubling the length of one side of an ordinary geometric square will scale the area of that figure by four, since the square has 2 sides, and 22 equals four. Or, when a geometric sphere’s radius is doubled, the volume scales to eight, because the sphere has three dimensions, and 23 = 8.

In contrast, when the one-dimensional lengths of a fractal are doubled, the space contained within that fractal scales up by a number that is not a whole integer.

Leaving aside the mathematical and technical description of fractals — In essence, I use them in forex trading so that my mechanical trading system can break down larger “cluttered” price movements into very simple and highly predictable views of trends and reversals.

Once these trends are visible, it’s easy for my automated trading system to take advantage of them. In particular, I’ve found that fractal signals based on smoothed moving averages (SMMAs) are very valuable for trading when I use them together with momentum indicators.

How do fractals help with forex trading?

Fractals predict reversals in current trends. When viewed as a set of price bars on a chart, the most basic fractal pattern contains five bars or candlesticks with these characteristics:

1. When the lowest bar is positioned at the middle of a pattern, and two bars that have successively higher lows are located on each side of it, this signals the change from a downward trend to an upward trend;

2. When the highest bar is positioned at the middle of a pattern, and two bars that have successively lower highs are located on each side of it, this signals the change from an upward trend to a downward trend;

Bullish and bearish fractals

Stated differently, when the forex fractal pattern shows the highest high at the center, and there are 2 lower highs positioned at each side, it signals a bearish turning point. And, when the pattern has the lowest low at the center, and there are 2 higher lows positioned at each side, it signals a bullish turning point.

Fractals are lagging indicators, so a mechanical trading system can’t act on them until they’re a couple of bars into the reversal. Still, since most of the significant reversals last for multiple bars, the trend usually continues long enough for me to trade it.

Fractals work best for forex trading when used together with a momentum indicator. Along with fractal indicators, I also use an oscillator such as the CCI indicator to facilitate entering a forex trading position as early and safely as I can.

Fractal Alligator indicators

My favorite fractal tool is the “Alligator indicator,” which is a moving-average tool that relies on fractal geometry and SMMAs. This indicator with a fancy name was introduced by senior trader Bill Williams around 1995, and it’s commonly available in MetaTrader software.

If you’re using MetaTrader, you should be able to easily add this fractal indicator by clicking on the menu tabs “Insert,” then “Indicators,” “Bill Williams,” and “Fractals.”

Alligator indicator lines confirm the direction and presence of a trend. Specifically, the Alligator indicator consists of 3 smoothed moving averages. Overlaid on pricing charts, these balance lines represent the metaphorical “jaw,” “teeth” and “lips” of the Alligator.

Carrying the metaphor further, it can be said that when the 3 balance lines are intertwined or converged, the Alligator is asleep with its mouth is closed. This indicates that particular forex market is trading in a sideways range.

Once a trend forms, the Alligator awakens and it begins to “eat.” The Alligator isn’t a picky eater; it can feast on either a bull or a bear. Once satisfied, the Alligator’s mouth closes and the creature returns to sleep.

The Alligator fractal indicator shows trends in the following way: When the price is trading above the mouth of the Alligator, i.e. the green balance line is over the red line which is over the blue line, and all three are aligned and pointing upward, yet still below the price line, this indicator signals a clear uptrend.

Conversely, when the price moves below the Alligator’s mouth, and the blue line is over the red line which is over the green one, and all three of the balance lines are above the price line, then the indicator signals a downtrend.

Finally, once the fractal forex trading Alligator has sated itself, the green, red and blue balance lines once again converge and cross over, signaling the end of the trend. At that point, my mechanical trading system takes profits, and then begins to watch for the next fractal forex trading opportunity.

In short, my mechanical trading system filters fractal signals by stating that the buy rules are confirmed only if they signal a value below the “alligator’s teeth” in the pattern, which means the center average.

Likewise, my sell rules are only confirmed if they signal above the alligator’s teeth. As well, I double-confirm the validity of Alligator signals by using the CCI oscillator.

Fractal forex GBPUSD

The fractal Alligator formula

The Alligator’s jaw, often depicted as a blue line, shows a Smoothed Moving Average containing 13 periods; this line is then moved 8 bars into the future;

The teeth, depicted with a red line, shows a Smoothed Moving Average containing 8 periods, moved 5 bars into the future;

The lips, depicted as a green line, shows a Smoothed Moving Average containing 5 periods, moved 3 bars into the future.

To reiterate, when the red and green balance lines cross over the blue line, it signals my mechanical trading system to “sell.” Conversely, when the red and green lines cross under the blue line, it signals a “buy.”

For purposes of programming a mechanical trading system for fractal forex trading:

  • n is the number of periods
  • High(n) is the highest price during period n
  • Low(n) is the lowest price during period n
  • SMMA(ABC) is a Smoothed Moving Average in which A is the data being smoothed, B is the period being smoothed, and C is the shift in time-period

The mechanical trading system calculates the balance lines:

  • [Low(n) + High(n)] / 2
  • SMMA (Median price n, 13, 8) = Alligator jaw (the blue line)
  • SMM (Median price n, 8, 5) = Alligator teeth (the red line)
  • SMM (Median price n, 5, 3) = Alligator lips (the green line)

Forex markets show many false trends. That is, often a “trend” may appear to begin, yet the price action soon settles back into a sideways range.

When using fractals, my strategy correctly identifies real trends and then follows them. Fractal forex tools such as the Alligator help my mechanical trading system reach through price clutter and focus on finding and trading the real trends.

My fractal trading method based on Alligator indicators

Here’s the simplest form of my fractal trading system based on Alligator indicators:

• Determine the entry point according to when the Alligator balance lines are intertwined, i.e. the Alligator is “sleeping” and when the CCI oscillator is indicating an overbought price condition;

• Execute new orders with 2% of the account equity;

• Places a stop-loss order at exactly 20 pips below the entry point;

• Sets an exit order to be triggered when more than two of the Alligator balance lines cross the candlesticks and/or when the CCI oscillator indicates an overbought condition.

Other ways to use fractals

Fractals are an easy way to see or confirm trends on any time frame. I program my mechanical trading system to check and see whether the fractals are showing lower lows and lower highs, or higher highs and higher lows. For my typical forex trading, I use fractals based on one-day, one-week, and one-month time frames.

The longer the time frame used to generate the fractal, the greater the reliability of the signals it produces. Also, the longer the time frame, the fewer the signals.

Also, I program my mechanical trading system to calculate fractals in order to set trailing stops. Since fractals show changes in trends, they work well to trigger my mechanical trading system to exit from trades when very-short-term reversals threaten to eat up the profits from a trade.

Trading with fractals and Fibonaccis

Beyond using the fractal Alligator indicator, fractal tools offer a great way to confirm Fibonacci signals. I’ve found that fractal forex trading works well when used for Fibonacci retracement levels.

I program my mechanical trading system to draw Fibonacci bands and calculate the fractals using daily time frames in forex markets such as EUR/USD and GBP/USD.

Then, I open a position when the price touches the most-distant Fibonacci band, yet only after my mechanical trading system sees that a daily (D1) fractal signal has occurred. The mechanical trading system exits the trade when a D1 fractal reversal occurs.

When using Fibonacci tools, fractals help pinpoint tops and bottoms with great accuracy. This gives me the confidence to trade at the right Fibonacci level. It’s easy – My mechanical trading system simply looks for the daily fractal parameter.

General considerations when using fractals

In order to double-check the signals generated from fractal indicators, my mechanical trading system uses other indicators such as the CCI oscillator to confirm fractal signals before trading. And, as with any type of trading method, use appropriate risk management measures to ensure that drawdowns are reasonable.

Fractals can be plotted in multiple time frames and used to confirm each other. One simple rule  is to only trade short-term fractal signals in the direction of long-term fractal signals, since long-term fractals are the most reliable. Use another indicator for safety such as the CCI oscillator to confirm the signal.

The Alligator and other fractal tools help

Fractals offer a set of powerful tools that you can use to strengthen your profits. Since mechanical trading systems are able to calculate fractal values and act on them quickly, there are plenty of fractal-based trading opportunities.

My own personal favorite is the Alligator indicator, yet fractals also work well with Fibonacci indicators and other trading strategies. In fact, fractal tools enjoy a relatively small yet devoted following among successful traders.

There are plenty of articles about fractals, as well as trader discussions about the basis for fractal forex trading success if you’d like to explore the topic further.

How do you use fractals in your trading? Share your thoughts on fractals below.

Gap Trading Made Easy

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Gap trading with a mechanical trading system offers independent traders a relatively easy method to capitalize on sudden market moves.

Gaps are often seen in the stock and fund markets. They are somewhat less common in the forex markets, which are usually more liquid and trade overnight.

In gap trading stocks, funds, futures and forex, a price “gap” refers to the open space seen on a chart when the price moves sharply up or down with no appreciable trading in between price points.

In its simplest form, gap trading involves buying based on the rise of a gap-up, and selling on the fall of a gap-down. Put differently, gap trading means buying when a price moves beyond the high of the previous time period without trading through that high. Likewise, gap trading means selling/shorting when the price moves below the previous time period’s low without touching it.

I use mechanical trading systems to program my way toward gap trading success by following some basic gap-trading rules and algo trading strategies.

Why do trading gaps occur?

Gaps can occur for a variety of reasons, such as sudden buying or selling pressure, especially by large players. And, they may result from earnings announcements or fundamental news. In fact, gaps can follow any sudden change in investors’ perceptions about a stock, fund, future or currency.

A gap can happen for either fundamental or technical reasons. For example, if a particular company announces higher earnings than expected, its stock price may gap up during the next trading session, if not overnight. Likewise, unfavorable corporate news can spark a gap down.

Gap trading

Or, a stock, fund or future setting a new all-time or long-term high may gap up for technical reasons. That is, a price move past a certain point may trigger institutions’ buying programs, which sense those new highs and spur even more buying.

Likewise, a stock or fund whose price moves below a threshold point may trigger investors’ rush for the exits and thus push its price further downward. Down gaps tend to accelerate more sharply than upward gaps.

And, in the forex markets, any report or other news may greatly widen the bid-ask spread. This creates a tradable gap either up or down.

In any case, you can program a mechanical trading system to recognize and respond profitably for gap trading.

Classification of trading gaps

For study purposes, gaps are usually classified as one of the four types listed below. It’s important to remember that these classifications will only be confirmed in retrospect, after the gap has occurred.

Once I’ve seen the follow-up movement, these labels are useful for categorizing which type of gap has occurred. These classifications help me to better understand how a given stock, fund or currency reacts under certain market conditions.

Fortunately, when using a mechanical trading system for gap trading I don’t need to know what will happen after the gap, only the circumstances which arise just before the gap.

Common gaps are defined as gaps which cannot be otherwise classified in terms of ending one trend and beginning another. They’re very “common,” hence the name. Usually, they’re uneventful and they simply represent an unexplained price gap from one day to the next. The volume during a common gap is often low and this type of gap is generally “filled” quickly. (See below.)

Exhaustion gaps happen at or near the end of a long or strong price run-up or price drop. They signal a final push toward new highs or new lows before the price movement reverses or begins moving sideways. For me, they’re a warning that the recent move is at its end.

Exhaustion gaps are characterized by higher volume and wide price difference between the price at the previous day’s close and the next day’s opening price. Using my gap trading strategies, it’s fairly easy for me to trade and profit from this type of gap. Higher volume is the key to recognizing them.

Continuation gaps can arise in the middle of any price trend. They are sometimes also referred to as “measuring gaps” or “runaway gaps.” Continuation gaps often happen around the midway point of a strong trend.

I interpret them as showing that on a particular day an exceptionally large number of buyers or sellers chose to move into or out of their positions. Perhaps they represent buyers who didn’t get aboard the trend earlier, but who are now piling in.

As well, this type of gap shows higher-than-average volume both during and immediately after the gap. Still, the volume typically isn’t even as high as it would be with an exhaustion gap.

Breakaway gaps occur at the completion of one trend or chart pattern. They mark the start of a new trend. Breakaway gaps offer great gap trading opportunities for me. From a technical viewpoint, they occur when a price manages to break out of its mid-term trading range – say a period of several weeks — or an area of congestion.

A congestion area represents a zone between resistance and support. To break out from a congestion area, a stock, fund, future or currency must receive a significant amount of new buyer interest (on the upside) or negative attention (on the downside).

A true breakaway gap will show a very large increase in volume, whether on the upside or downside. The volume should be larger than with any other type of gap.

In any case, this represents a major turning point in price direction and in my experience the move is likely to continue for the mid-term or long-term.

I account the breakaway point as the new resistance or new support level. With my mechanical gap trading system, I look to harvest substantial gains from this type of breakout.

Most importantly, I avoid falling into the trap of assuming that a breakaway gap will retrace. Once my position is secured, I stay aboard for the ride. I’m confident that the new trend will continue for a reasonable period of time, at least until the next reversal on very high volume.

Gap fills

One other term-of-art often used to describe trading gaps is the word filled. When a gap is “filled,” it means the price has quickly returned to its pre-gap level.

Gap fills typically happen because buyers decide they were over-optimistic or over-pessimistic. Or, the news which triggered the gap is quickly proven false or overblown.

When prices move above or below technical resistance or support levels, I rely on my mechanical gap trading system to determine whether the gap is likely to be filled, and proceed accordingly.

For example, since exhaustion gaps show the end of a trend, they are likely to be filled:  The price gaps, then retraces. So, my gap trading system uses data from the previous trend to determine the appropriate entry and exit points to take advantage of both sides of this fairly predictable move.

Gap fading

Gap fading described when a price gap is filled during the same trading period when it occurs. The gap movement “fades away.” It occurs when investors’ exuberance or despair is quickly proven unfounded. This scenario often arises during earnings season.

I and other short-term traders use mechanical gap trading systems to recognize and harvest gains from these quickly-reversed moves in stocks, futures and forex markets.

General gap trading strategies

In markets that I’ve been watching closely, I use several gap trading strategies. In order to profitably trade gaps, I need to keep several things in mind.

First, it’s important to realize that when the price begins to fill its gap, it usually continues until the fill is complete. This is because a gap doesn’t have any nearby support or resistance. Otherwise, that gap wouldn’t have occurred in the first place.

Second, I keep in mind that continuation gaps and exhaustion gaps are predictors of price movements in opposite directions. So, I make sure that my mechanical trading system considers gaps in relation to the recent trend which precedes them. If not, I might trade in the wrong direction.

Also, I ensure that my gap trading system makes decisions based on volume as well as price. To help classify a trading gap for purposes of programming my algo trading system, I make a distinction between high volume, medium volume and low volume.

For a successful breakaway gap, very high volume must be present. And, exhaustion gaps are characterized by somewhat lower volumes, although still higher than usual.

I often watch stocks and funds that trade mostly during daytime sessions. Then, I program my mechanical trading system to buy their shares in after-hours trading when positive earnings are unexpectedly released.

If I’ve done my homework correctly, at the beginning of the next daytime trading session there will usually be a gap up when institutional investors crowd into the stock. As well, I use my mechanical trading system to spot and act on technical factors that signal a likely gap the next day.

This gap trading strategy also works well with currencies. My mechanical trading system tells me whether to buy or sell when a currency gaps up on low liquidity and there is no nearby overhead technical resistance. This works especially well during geopolitical events which seem likely to continue for more than one or two days.

Likewise, I use gap trading tools to profit by fading the gaps in the opposite direction. For example, if the price gaps up based on speculation when there’s nearby resistance, I fade the gap with a short order. So, I ride the price from its failed gap-up level while it goes back down to its normal price range.

Gap trading in the forex markets

The forex markets are open twenty-four hourly except for a weekend closing. So, for charting purposes forex gaps are visible as large candles when the market reopens.

Here’s the gap trading strategy that I use in forex markets. By programming my mechanical trading system with the following basic rules, I’m able to harvest satisfactory gains.

First, the direction of my trade must always be in the same direction as the current hourly price. My mechanical trading system watches for the currency to gap above or below its calculated resistance level according to a thirty-minute price chart.

Next, my system looks for a price retracement back to the calculated resistance or support level. This shows the gap is being filled — The price is returning to its previous resistance-turned-support or support-turned-resistance level.

From a charting perspective, I look for a candle showing price continuation in the same direction as the gap. My gap trading system takes this as a confirmation of continuing support or resistance at the indicated level, and trades accordingly.

Double check volume before trading

With help from my mechanical trading system including the appropriate algorithms, I’ve been enjoying good results in trading gaps in the prices of stocks, ETFs, futures and currencies.

I’ve found that volume is the most important qualification when determining the type of gap and assessing the likelihood that the price move will continue.

To avoid becoming emotionally caught up in any price move, I rely on my gap trading system to quantify and verify the volume before sending any buy or sell orders. I set my algo trading parameters to check a variety of pricing sources before generating orders.

If my mechanical trading tools detect high-volume resistance that is preventing the marketplace from filling a gap, then my system double checks the volume and price data to ensure that my trading premise is correct before proceeding.

Of course, I always program my gap trading system with appropriate stop-loss orders. Some traders believe that gap trading is risky. Yet, with the right mechanical trading tools it offers plenty of opportunities for fat gains.

In fact, gap trading by using mechanical trading systems is currently a hot topic:  A book regarding ETF gap trading has recently been published, and there are many academic reports and quant-focused articles about how to trade gaps.

I recommend that you explore the possibilities of gap trading with a good mechanical trading system. With the right tools, gap trading can be both predictable and profitable.