Stability in Chaos of EUR/USD
FX markets are inherently unstable. Statisticians often say there are no stationary processes within the market – it is all random. Well, not so much. There are a few things stable in the sea of instability:
- Instability itself – which is great as this provides the opportunity to profit
- Liquidity Gaps – those are sharp movements down or up the price
Let’s first look at what the liquidity gaps are in my definition and in my quantitative research. Liquidity gaps are sharp movements up or down the price on EUR/USD as is seen on a 10-minute timeframe. Sharp movements are one-directional movements larger than 11 pips in spread (absolute difference between Open Price and Close Price on a 10-minute price bar) with Open Price and Close Price deviating not more than 3 pips from the respective High and Low of the same bar.
Visually, the liquidity gaps on a 10-minute time frame on EUR/USD will look similar to this:
Image 1: Regular Mid-Size Liquidity Gap on Regular Trading Volume Without News
Now the interesting fact is: 95% of those gaps (excluding news and extreme volume) will close within 3 trading days.
The research has been based exclusively on EUR/USD pair and provided statistically similar/stable probabilities within 3-month periods for the past 7 years.
By closing I mean the price will reach back to the levels from which the price has sharply fallen down or risen up.
Another interesting fact is – the smaller the liquidity gaps are (e.g. 12 - 15 pips vs. 20 - 30 - 50 pips gaps on the 10-minute time frame) the faster on average the price will reverse to test the levels from which the price has fallen/risen initially. Most small gaps (over 75%) will close within 2 - 6 hours as can be seen on the example image above.
This suggests a principle of strong dynamic price-reversion. However, it is also always combined in some ways with trending. Trending is defined as price following the direction of the liquidity gap for a certain period of time until reversion is recorded.
From the example screenshot price action, after the upward gap 1, the EUR/USD price moved further upwards to create another gap 2 and even further up to test the top of the price. This was a trending move in the direction of the gap. The trending after initial gap can be from as little as 5 pips to 250 pips. The big 250 pips movements after a gap (in the direction of the gap) are usually formed by continuous gaps on extremely high trading volume.
Continuous gaps on extremely high trading volume are closed with smaller probabilities within 3 days, however, they can be closed within 5 - 6 trading days (up to 75% probability) and usually provide the directional trend accompanied by a move after the gap of about 120-150 pip. Such gaps are usually, but not necessarily, formed by news announcements.
How to trade this information?
1. Trend-trading liquidity gaps (in the direction of the gap) if they are on extreme trading volume, continuous and are caused by major news announcements. Only after the gaps have been formed. This strategy can be traded on higher than 1:5 leverage since the stop loss can be set immediately after the trade, in case the price continuous in trend-direction and closed on discretionary profit. Stop loss would be set initially at -20 pips to the entry price and set at break-even upon profitability.
2. Trade against the direction of the liquidity gap if it was not :
- on extremely high volume
- created by major news announcement
- bigger than 25 pip in size
This strategy is more risky, as the exact trend movement (in the direction of the trade) is not known beforehand ( can be from 5 to 200 pips trend movement before reversal to close the gap).
3. Your comments are welcome on how to position trades based on this information.