With the forex markets trading 24 hours a day, price gaps are relatively uncommon. Does the occasional weekend gap contain a statistical edge?
Let’s find out by backtesting the EURJPY’s gaps over the past 18 years!
The strategy programmed below can be downloaded in the Free Strategies section.
Over the years, I have repeatedly found that forex markets are mean reverting in general, with the possible exception of the JPY pairs.
Does mean reversion apply to weekend gaps as well? And if it does, can we program a strategy to exploit this phenomenon?
Before finding out, let’s cover some causes and examples of forex weekend gaps.
What Causes Forex Weekend Gaps?
Weekend gaps are caused by unforeseen geopolitical events.
Military conflicts, political uprisings and natural disasters often fall into this category.
A memorable example would be the capture of Saddam Hussein in December 2003. EURUSD gapped down 150 pips when markets reopened on Monday.
I have observed that these weekend gaps usually reverse completely by the middle of the trading week.
Due to thin liquidity, markets typically overreact to the weekend news when trading reopens on Monday. With increasing liquidity in the ensuing London and New York sessions, this imbalance tends to correct itself.
To find out whether these gaps can be exploited, a few observations aren’t good enough.
Let’s get a decent sample size by doing a long-term backtest on the 1-hour EURJPY.
Programming a Forex Weekend Gap Strategy
These are the entry conditions for fading the weekend gap:
- It is Monday, AND
- The weekend gap exceeds 3x the 5-period ATR.
Notice the weekly close has a time shift of 1 bar, meaning I’m referencing the most recently completed week.
The daily open references the current day’s open, so a shift of 0 is used.
Trade management is as follows:
- Profit target: Previous week’s close
- Stop loss: 3*ATR(5)
The decision to use ATR instead of pips for the entry and exit conditions should improve the strategy’s adaptability. This will help it perform more consistently across various markets, or across different volatility regimes in the same market.
Since I’m only going to fade the weekend gap once, I’ll set my maximum trades per day to 1.
To limit market exposure, I’ll exit the market on Friday at 23:00 hrs. The gap reversal, if successful, should have been completed by then.
That’s it for programming. Here’s an example of a successful trade on the EURJPY.
Backtesting the Forex Weekend Gap Strategy
Here’s the 2003-2021 backtest on the 1-hour EURJPY.
That went much better than expected. The only bummer is the miserable sample of 48 trades. Of course, since sizeable weekend gaps are uncommon, you shouldn’t expect the strategy to trade much.
To bump up the sample sizes, you can backtest the strategy on other markets too. Here’s a few more successful 18-year backtests from the AUDJPY, USDJPY, AUDUSD and NZDUSD.
It does appear that forex weekend gaps have a tendency to reverse by the end of the trading week. This statistical edge can easily be exploited, as long as you have strict risk management rules to protect your downside.
Due to the low trading frequency, I don’t recommend trading this strategy in isolation. You can instead include it as part of a diversified portfolio.
If you want to check out AlgoWizard’s awesome programming capabilities, don’t forget to claim your 20% discount.
As usual, you can download the weekend gap strategy in the Free Strategies section.