The mechanics of gapping

It’s not true that the forex trading market never gaps, as has been demonstrated on opening repeatedly this year. But the mechanics of gapping are slightly different here than in stock trading.

Almost all gapping in the forex trading market occurs at open, when Auckland trading institutions come online at 9:00 AM local time (7:00 AM Canberra time, Sunday evening in Europe, and early Sunday afternoon in North America). This is the first opportunity international forex traders have to respond to events that have taken place since Friday’s close, and their online orders are waiting for the trading platforms to process. This spurt of activity as the computers come online, called the Sunday open gap risk, is one of the major causes of gapping in the forex trading market.

Gapping does occasionally occur during the week’s trading, in response to a geopolitical event (think terrorist attack), central bank intervention, or dramatically surprising fundamental data release. This occurs because interbank markets cease accepting bids and offers in the minutes prior to (if the event is scheduled), and immediately following, such events. With no prices to reflect from the interbank market, online trading platforms simply display the last known price.

This situation holds until the event is past, the interbank markets adjust their pricing to reflect the aftermath, and again accept bids and offers from financial institutions. While this scenario may require no more than thirty seconds from market freeze to release, it’s not unknown for prices to gap fifty to eighty pips as a result of a major incident.

Just as in stock trading, gaps blow past stop-loss and take-profit levels without triggering them, leaving unexpected profits and losses in their wake. As well, there’s the risk of slippage, when one’s orders including stop losses aren’t executed at the specified price but at the closest available, which may or may not be a good thing for the trader. The broker’s obligation is to use his or her “best efforts” in filling orders, and prices are rarely guaranteed.

Because it occurs in the interbank markets, the risk of gapping affects everyone, commercial and retail, institutional and home-based traders alike. As discussed above, stop losses are no insurance against intraday gapping, and trading risky fundamental announcements can lead to significant losses as well as profits.

The only protection against gapping is to be out of the market preceding such announcements and to exit all open positions before Friday’s close. Unfortunately, for obvious reasons, there’s no protection against gapping caused by unplanned geopolitical events, such as earthquakes or central bank interventions.