If you have an order flow tool like JigSaw or BookMap then you have likely heard about liquidity gaps. In this post - we are going to discuss some common examples of liquidity gaps; and discuss a cycle of potential gaps each month.

Market Cycle

Each month we have routine data drops; CPI, PPI, NFP, GDP … it’s a long list. For my Liquidity Gap play we look at the list of economic data releases that take place at 8:30am Eastern. We never know for sure there will be a large move or even if the move will provide us with a tradable setup. But - we DO know WHEN the chance of a Liquidity Gap could form and that is enough.

In the picture above - we have a large red candle that dropped price at 8:30am when some economic data came out. That move - created a gap in the liquidity. This is what we want to focus on in todays write-up. I have met a number of traders over the years who want to trade the red candle above; I argue that any attempt to trade the move - is considered “high risk.”

It’s possible to jump into the move as it unfolds. If we go into a smaller timeframe - like a 10-second chart or a small Tick-chart (maybe like a 125 or 350 tick) we could possibly see some structure to the move and find an opportunity.

But - at the OEC we continue to sing the song of caution and “do the easy stuff” first; save the complex / advanced stuff for later in your trading career. How will you know your advanced enough to trade that big candle in the picture above? You’ll know your ready when you can develop your own approach to that trade without someone telling you how it can be done.

Opportunity

If we are not going to trade that big move - then what are we going to trade? The move back to the open of that big candle. This is a concept that I call “destination” trading. We have an idea about where price is going and we can participate in the trade over and over again until we reach that destination.

We do not know what the entry signal will be; or if we will get an entry signal at all! We just have the place where price is supposed to go and we want to use that information to assist us with trading opportunities. This gives all traders a shot at the markets. Scalpers can get repeated micro setups, price swing traders can get a few rotations in price as it begins to close the gap and position traders can stay in through the whole move - understanding that price will reach it’s target.

On the right side of the picture above - we can see the buy orders (green) and the sell orders (red) that is resting on the DOM - or the active trader. That is “liquidity” - and if price spikes or drops really fast (like in the picture below for example) then it leaves a “liquidity gap” behind.

We call it a liquidity gap - but in reality there will be orders on the DOM. They will just be “weak hands” or new orders (since any existing orders were wiped out when the move happened). Markets like to fill gaps - so if we get a economic data point that moves markets suddenly - we have the potential for a Liquidity Gap set-up.

The first large move which comes from the economic data release - is not the trade. It’s the setup. The trade comes after we get that big move. The big move can be analyzed; we can evaluate the market structure of the move and lay out levels of opportunity based on that large candle.

I am kinda picky about this strategy. There are multiple setups to trade a Liquidity Gap so don’t imagine that this is the only one - or that they all will look like this. We can get a Liquidity Gap any time price makes a large sudden move.

For the one we are discussing today - it’s based on the idea that an 8:30am data print like CPI, NFP, PPI and other 8:30am data gives us a time and place to see a possible Liquidity Gap.

In the picture above - we had a bullish move at 8:30am. Notice that there was no real move lower in that big candle? There is a little red circle showing “no wick” down there. This is one of my criteria - I do not want to see a move in the opposite direction.

Notice also that we closed near the high of the candle? We do not want to see price pulling back after making the big move - we want to see it close within the “last 20%” of the candle.

Depth

Why does this particular gap close strategy work? There are a number of theories; I believe that there are pre-programed market trading Algorithms (we’ll just call them “Algo’s” from here on out) who are coded to trade the economic report.

The report comes out and the algo triggers - trading a defined number of contracts. One reason I believe this is because of the consistent “no wick” in the signal. It’s a single direction move - and it happens right at the time of the data release - perfectly. Too perfectly to be anything else except machine trading.

So - we get the report and the algo trades the contracts it was supposed to trade and now that it’s done the job - price stops moving in that direction. Now - human traders step into the market and begin to respond to the move. They are looking at signals from the markets and they are seeing the lack of order flow structure within the DOM and the order flow trading tools.

Candle Sentiment

In the picture above - I have shared a Candle Sentiment chart with 0, 20, 40, 60, 80, & 100% guide. This is just a example of that “20%” comment above. We want to see the candle close in the upper 20% if it was a bullish move or in the lower 20% if it was a bearish move.

Candle Sentiment is important to this strategy because it adds trapped traders to the mix. There will be traders who tried to buy at the high of the move or traders who tried to sell at the low of the move and they were “last in-first out.”

These trapped traders provide liquidity to the market as the reversal starts - closing their losing trades. The Algo which moved price so far and fast did not have sentiment; it was not “bullish” or “bearish” - it just needed to execute a defined number of contracts.

Sure - we can see that the algo bought something (bullish bar) or sold something (bearish bar) but we can not know if that algo was buying to close a short trade - or selling to close a long trade. Once the algo has done it’s business the flows it provided are gone and price begins to unwind the sudden change.

Price begins to revert back to the mean.

In the picture above - I have shared a follow-up example of how Liquidity Gap’s can be anywhere. In this one - we had a 10AM event which gave us a pop up - then at 12:30PM we had another one which took us lower (which we filled in 15 minutes) - and then we dropped at 3PM and closed the 10am gap before popping back up to close the 3PM gap. Wooo … lots of gaps that day!

In the picture above - we can see the June CPI print moved price but did not provide us with a gap close setup. There was large wicks formed on each side of the 5-min candle and price closed very near to where the candle opened.

In the picture above - I believe there were multiple algos and each one was doing what it was supposed to do without any consideration of the other algos. This makes sense when we consider the various types of trading groups out there.

We have governments, corporations, hedge funds, banks, trading firms, mutual funds, Insurance Companies, Sovereign Wealth Funds, Family Offices, Prop Firms, Market Makers… and others I am sure. All of these groups have their own interest at heart and will use algos for their own purpose. If their algo is trading with some other groups algo - then these algos can whip price in both directions and cancel each other out.

What-ever the reason - if the economic data at 8:30am gives us a candle that has large wicks on each side then the Liquidity Gap strategy has no setup and we would move on to something else.

Bonus

Just because there is no Liquidity Gap setup - does not mean the data print was worthless. We are taught in technical analysis to pay attention to large candles. We can analyze the large candle and define new levels. Start with the Open, High, Low, and Close of that candle and then mark the 50% of it.

From there - we can project levels above and below that candle - 50% and 100% beyond that move.

In the picture above - we have the same chart as before but I have added some measurements to it. The green box was the economic event and then the blue box above that is “50% measured move.”

Price popped into that measured move and stopped. Sure - we overshot the level - but that was a gift which showed us the new SSL zone. (SSL = sell side liquidity). Now - we have a market high on the trading day with a clean SSL above us.

That large candle came back into play multiple times throughout the trading day; all of this is just an example that even if the Liquidity Gap does not form - we still have opportunity through the trading day.

Above is another picture of an 8:30am economic data print that didn’t provide us with a Liquidity Gap trade; that candle pulled back from it’s high to close near the 50% mark. Once we snap a fib onto it we can see price tested the 123.6% after breaking out of the range.

While I do not have the projection to the downside - price also tested the 123.6% level there as well. This is a classic example of how large candles can provide tradable opportunity. Even the -1/2 back offered opportunity to trade.

Liquidity Gap

Market Cycle

Opportunity

Depth

Candle Sentiment

Bonus

What Moves Markets

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