Gaps are usually defined as a strong imbalance of supply (sell orders) or demand (buy orders) on a market open, causing price to open above or below the previous session’s settlement price.
At some point in the future, prices normally (but not always) return back to the origin of these gaps and close them. It is at this point that a lot of professional traders are waiting to take positions in the direction of the gap from the past, unlike the retail trader who bought or sold the market the day of the gap and usually bought the high of the move or sold the low of the move.
In this article, I would like to discuss the two different types of gaps that futures traders can expect to find on their charts:
The chart below illustrates what these look like on a chart.
Click to enlarge
Looking at the chart, we see the 10-year Treasury futures contract traded on the CMEGroup Exchange. The chart is, of course, an “unadjusted continuous” type.
The gaps that are highlighted in yellow and blue look like any ordinary gap a futures trader may see on their charts. However, to the trained eye, these are two different types of gaps.
The yellow box gaps are known as natural gaps. These occur because of a news event that broke while the markets may have been closed or because of a series of technical trading systems that put a lot of buy or sell orders on the open. These are called “MOO” orders (market on open). Whatever the reason for the gap, it was caused by excessive imbalance of supply/demand (sell/buy) orders on the open.
You will notice in the chart that when price returned to the gaps of yellow boxes, the market respected that level, even if temporarily. That is because traders were patiently waiting for price to return to the origin of a big move and then take their positions.
These are your everyday gaps that we see on our futures charts. There is nothing new about them other than we might want to pay attention to them when price comes back to that gap vicinity again in the future.
The other type of gap on this chart in the blue circles is called a rollover gap. These will only be seen on unadjusted continuous futures charts. These gaps tend to be filled just like any other gap, but here is the difference: they were not created by a supply/demand imbalance like our natural gaps. So when price comes back to these gaps, we do not have a true supply/demand level.
My observation is that while these gaps do get filled as frequently as a natural gap does, they also get exceeded in price enough to stop out the majority of traders who try and trade these like a natural gap. Since this gap was not created from a supply/demand imbalance, it was simply a function of one contract expiring. The charting package begins to plot the new contract price on the same chart.
Let’s look at a futures contract for a moment.
All futures contracts expire at some point.
Futures contracts have multiple months of contracts trading at the same time.
Each of these other months usually have a different price due to something called carrying charges (cost associated to storing the commodity).
Because of these contract expirations, our chart packages needed to create an un-adjusted continuous chart. This means that each time a contract is near expiration, the charting package will replace the soon to expire contract with the next contract in the cycle (called rollover). For example, the June Treasury markets just rolled over to the September contract on May 30.
To get a better idea of how this rollover looks on an unadjusted continuous chart, let’s look at the prices of these two contract months on the day of rollover:
June 10-Year Treasury – 130’155
September 10-Year Treasury – 129’155
There is one full point or one handle difference between these two contract months. This would mean that on the next day when the chart package begins to plot the new September prices on the chart that was charting the June prices, there will now be a 1’000 handle difference in price. Since September is trading one handle lower, there will be a gap down of about 1’000 handle the next day even if there is no news that would impact the Treasury market. This is referred to as a rollover gap.
Since the financial futures (stock indexes, treasury market, and currency market) all expire the same months (different days) during the year, you can expect to see at least four rollover gaps on your unadjusted continuous charts each year.
To better understand when these rollover gaps may occur, a trader should be familiar with the contract specifications of the product they are trading. The contract will list the last trading day of the futures contract. Once you know the last trading day, you can subtract the following number of trading days, not calendar days, from the expiration, and you will know if the gap you see on your chart was a natural gap or a rollover gap.
Stock indexes = seven days prior to expiration
Treasury market = 14 days prior to expiration
Currency market = three days prior to expiration
I know this may sound complicated and or confusing, but nobody ever said trading was easy. Your competition, the retail novice trader, will not do the extra work to understand the difference between these two types of gaps. Perhaps we can learn something from this as so many of them lose money in the market on a regular basis.
"Before you spend, earn. Before you invest, investigate. Before you retire, save. Before you die, give.
-- William A. Ward
Editor's note: This story by Don Dawson originally appeared on Online Trading Academy
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No positions in stocks mentioned.