Unexpected events can stimulate significant volatility in the forex market, especially after the weekend. These events, whether geopolitical, economic or related to natural events, can cause market gaps up or down when forex trading resumes Monday morning.
An event that directly influences currency valuations can significantly affect your bottom line as a forex trader, especially if you hold positions over the weekend. In addition, if you trade during periods of significant volatility, you may encounter slippage in your stop and market orders.
In this article, Benzinga explains what market gaps and slippage mean to forex traders and how these market phenomena can affect your trading success.
What is a Market Gap in Forex?
Among forex traders, a market gap refers to an abrupt break in the continuity of an exchange rate with an absence of trading in the interim. Gaps in an exchange rate can occur to the upside and the downside.
Gaps in the market for currency pairs typically occur when trading resumes on Monday morning after the weekend when the forex market does not operate. Nevertheless, gaps can also occur while the forex market is open, especially upon the release of economic data or other important news.
The appearance of a gap usually suggests that new information has come out that must be rapidly discounted by the market, and a gap fills when the exchange rate of a currency pair moves back to where it was trading immediately before the gap occurred.
Gaps are used by some technical analysts who aim to identify the type of market gap so they can better determine whether it will be filled or not. Four main types of gap patterns exist that can each provide a useful trading signal to observant forex traders who identify them properly.
These gap types include common gaps, runaway gaps, breakaway gaps and exhaustion gaps. A schematic diagram of each type of gap pattern appears in the image below.
Note that the forex market usually retraces to fill a common or exhaustion gap, but that does not happen with breakaway or runaway gaps since the market will subsequently move sharply in the same direction after the gap is formed. Traders observing a gap should aim to first correctly identify its type before entering a trade assuming that the gap will be filled.
What is Slippage in Forex?
Slippage in forex can be defined as the positive or negative difference between the expected exchange rate of a trade and the actual exchange rate at which the trade was executed. Slippage occurs largely on stop-loss orders when the market gaps either up or down, but it can sometimes occur on market and limit orders in unusually volatile markets.
As an example of negative slippage, consider a situation where you are long the EUR/USD (EU euro vs. U.S. dollar) currency pair. The prevailing market exchange rate is 1.0635 bid at 1.0638 offer when you enter a protective stop loss order to close out your long position at the market if 1.0620 trades.
The European Central Bank (ECB) then makes an unexpectedly dovish announcement about interest rates right after your order was entered, so the EUR/USD exchange rate suddenly drops below 1.0620, and your stop loss sell order gets filled by your broker at 1.0615.
The difference between your stop order level and the execution level is known as slippage. In this example, your order was affected by negative slippage of 5 pips or 0.0005 since the stop-loss order was filled at 1.0615, which is a less favorable exchange rate to sell EUR/USD at than the 1.0620 level you had expected when your order was entered.
While trading slippage can theoretically also be positive, slippage is typically negative in practice since many online forex brokers will fill you at your limit order’s exchange rate even if the market actually gapped through it in your favor. The vast majority of slippage events forex traders worry about thus involve the trader losing more money than they expect when they place a stop-loss order.
What Causes Market Gaps and Slippage?
Increased volatility and gaps in a currency pair’s exchange rate contribute significantly to the frequency of order slippage and the risk of holding a position. Also, the causes of market gaps can be numerous in forex, especially since you have to consider the elements affecting two nations’ economies and how they affect relative currency valuations.
The three main causes for gaps and slippage consist of:
- Economic data releases: Forex pairs react to major economic releases from both countries. Economic data such as inflation numbers, interest rates, employment, gross domestic product (GDP) and each nation’s trade balance can significantly affect a currency pair’s volatility, especially if the number released deviates significantly from the market’s consensus.
- Major events in the news: Any major and relevant geopolitical event like national elections, wars, extreme weather or natural disasters can heighten the level of forex market volatility, especially if the event covered by the news release was unexpected.
- Post-weekend or holiday: Many gaps occur after a major holiday or as trading in the forex market resumes on Sunday evening after the weekend, especially if a significant market-moving news item came out over the weekend.
While major gaps occur after the weekend or upon the release of important news, small gaps can often be discerned on exchange rate charts. Charts of volatile currency pairs with short timeframes such as a 1-minute, 5-minute or 15-minute chart often show gaps that can reflect substantial uncertainty or large transactions occurring in the forex market.
Market Volatility
Volatility in the forex market measures how much change occurs in an exchange rate over a certain period of time. The more the exchange rate fluctuates over a certain time frame, the higher the volatility in the currency pair.
The level of volatility depends in large part on the liquidity in the currency pair. In many cases, the higher the liquidity in a currency pair, the lower the volatility in the exchange rate. The reason for this is that the forex market tends to trade more smoothly and display fewer gaps if more traders and market makers are actively operating in a currency pair.
With that noted, even the most liquid currency pairs can have their exchange rates strongly affected by an impacting news item or an unexpected monetary policy announcement by a relevant nation’s central bank. Such events can cause a major spike in volatility that can negatively affect the pair’s liquidity and might trigger slippage events.
Trading Outside of Normal Hours
Certain time frames can be especially challenging to trade currencies. Even though the global forex market stays open 24 hours a day from Sunday evening to Friday evening New York time, it can still show significant shifts in volatility and liquidity during the trading week.
According to many seasoned forex traders, the worst times to trade currencies with strategies that do not benefit from high volatility, market gaps and order slippage are:
- Around the time of major economic releases: Most experienced traders avoid trading just before, during and shortly after the release of important economic data. Affected currency pairs generally become quite illiquid at these times due to the risk to market makers. The forex market generally calms down and regular trading conditions resume roughly half an hour after an economic release has become widely known to the market.
- Sunday night NY time: The forex market trades down under in Auckland and Sydney on Sunday night NY time, but it generally displays low liquidity and market makers quote relatively wide dealing spreads during that time frame until Hong Kong and Tokyo open up in Asia.
- Friday afternoon: Many forex traders prudently square their positions on Friday at the close of the trading week to avoid the risk of the currency market gapping over the weekend. The possibility of a major news release occurring over the weekend may cause their position to lose money when they cannot do anything about it.
Leveraged Trading
Retail forex traders usually operate using considerably higher levels of leverage than stock traders do. While leverage does not generally directly affect the level of exchange rates, it can contribute to the formation of gaps in the forex market.
For example, when a majority of currency traders have positioned themselves with leveraged positions on just one side of the market, an unexpected adverse move could cause the exchange rate to gap as they quickly liquidate their losing positions via stop-loss orders.
When such market gaps occur, slippage on the stop-loss orders placed by adversely affected retail forex traders typically follows and poses an additional risk of loss. Prudent forex traders should factor in this added risk of leveraged trading when managing the open positions in their margin trading accounts.
Effects of Market Gaps and Slippage
Gaps in the forex market represent a lack of liquidity that is usually caused by fast or disorderly market conditions. In most cases, gaps tend to fill at some point in the future, and this can give observant traders a basis for establishing a position in the market.
Although not all gaps are filled, many gaps are followed by corrective market action. This tendency results in the exchange rate subsequently trading in the opposite direction of the gap and eventually closing the gap.
While many traders regard gaps as negative market events because of the lack of liquidity and order slippage that can result, gaps can be quite useful to technical analysts who identify them correctly. For example, exhaustion gaps can indicate a reversal in the exchange rate’s trend, while runaway gaps suggest that a continuation of the prevailing trend seems likely.
Slippage does not really affect exchange rate levels in the forex market, but it can cause dissatisfaction with a broker that fills a client’s order at a worse level than expected. Some online forex brokers prefer to avoid this issue by offering no-slippage accounts that guarantee their client's order executions will be at their chosen levels.
Keep in mind that no-slippage accounts might have wider dealing spreads or charge an extra commission. These fees help compensate the broker for their possible losses when executing no-slippage orders for their clients.
Loss of Profit
Slippage on a stop order almost always results in a loss for the trader. When slippage occurs, which tends to be after the currency pair has gapped in one direction or the other, stop orders typically get filled at an exchange rate worse than the limit on the stop order. This eventuality tends to eat away at a trader’s profits, especially when stop-loss orders get executed at exchange rates significantly worse than the trader’s limit. One way to avoid gaps and slippage is to avoid trading during the periods mentioned above. Most experienced forex traders avoid trading gaps and therefore avoid slippage on their trades.
Increased Risk
Facing increased trading risk is an effect of volatile markets displaying market gaps that result in order slippage. While gaps can be lucrative if you happen to be positioned on the right side of the market, your risk of loss can also increase significantly in a volatile market if you continue to hold a position.
Delay in Execution
When forex market conditions are highly volatile, the likelihood of market gaps and slippage increases. This can result in stop-loss orders not being executed at your desired exchange rate. In addition, the presence of fast market conditions means that the execution of market orders can be substantially delayed and done at unfavorable exchange rates. Requotes may also occur more frequently and usually occur in a direction that does not work to your advantage.
Strategies to Avoid or Reduce Market Gaps and Slippage
Many traders devise and use creative strategies to help them reduce the risk to their trading accounts from slippage and market gaps. The following sections discuss some of the more popular ways to do this.
Monitor Market Volatility
Monitoring market volatility can help you reduce the impact of market gaps and slippage on your trading account. For example, you can monitor an indicator like historical volatility or the Average True Range (ATR) to assess the recent level of volatility the forex market has been experiencing in a currency pair and hence its likelihood of showing gaps that could result in adverse order slippage. You can then size your positions in that pair accordingly by taking larger positions in a pair with low volatility and smaller positions in a pair with high volatility.
Use Limit Orders
Placing limit orders in the market to trade at a particular level that is more favorable than the present market level could possibly increase your profits, especially if a market gap occurs in your favor. Some brokers might give you positive slippage on your limit order levels if the market gaps through them in an unusually volatile trading environment. Using limit orders can also reduce your risk of losing money from slippage since they might be executed before a stop loss is triggered.
Use Stop-Loss Orders
While stop-loss orders are generally subject to slippage at brokers that do not offer no-slippage accounts, using them can help you reduce the impact of market gaps on your account since you will already have an order in the market rather than having to take urgent action to enter a market order in a fast market. If you already have a trading position in a currency pair that has gapped, you might want to liquidate the position sooner than later, especially if the position is losing money. Even if the position appears to be a winner after the market gap, it can rapidly turn into a losing position. Depending on the situation, you might want to immediately take your profits and re-evaluate your position before jumping back in.
Best Ways to Avoid Slippage
While volatile trading conditions may be a boon to some experienced traders, they can also quickly obliterate a novice’s trading account because of the risk of getting whipsawed as the market swings sharply to and fro.
Perhaps the best way to avoid losing extra money from negative order slippage often caused by a gapping market is to not hold a position in volatile market conditions, such as those that occur just after a major news event or economic data release. You may also want to avoid holding a position over weekends and holidays when gaps are more likely to occur.
Another way to reduce your risk of slippage-related losses is to lower the leverage ratio you use on forex trades when the market gets more volatile. This practice can help because any extra losses you incur from slippage will be magnified by the leverage ratio you chose to use.
Frequently Asked Questions
Do gaps always close in forex?
No. Common and exhaustion gaps generally close or fill, while breakaway and runaway gaps typically do not.
What are the different types of gaps in forex?
Forex traders should know about four different gap patterns. These include the common and exhaustion gaps that typically fill and the breakaway and runaway gaps that generally do not fill.
How do you avoid slippage in forex?
While order slippage is a well-known trading hazard at most online forex brokers, some brokers do guarantee stop-loss order executions at your order level. You could thus open an account with such a broker to avoid slippage.
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About Jay and Julie Hawk
Jay and Julie Hawk are the married co-founders of TheFXperts, a provider of financial writing services particularly renowned for its coverage of forex-related topics. With over 40 years of collective trading expertise and more than 15 years of collaborative writing experience, the Hawks specialize in crafting insightful financial content on trading strategies, market analysis and online trading for a broad audience. While their prolific writing career includes seven books and contributions to numerous financial websites and newswires, much of their recent work was published at Benzinga.