Many are hesitant to invest in the stock market because of the large gaps in prices. It is not uncommon to see a stock that closed the previous session at $55 open the next trading day at $40. This kind of volatility can result in massive losses, but this is the risk that investors take when trying to make money in the stock market.
Regardless of the type of order placed, gaps are events that cannot be avoided. A common strategy is to use stop-loss or limit orders as protection to mitigate the impact of the gap. However, that isn't always the best solution.
- Gaps are often news-driven, with a rush of buyers jumping into or out of a security, propelling it one way or the other.
- Stop-loss orders and limit orders are two ways to protect yourself from losses that occur as a result of gaps.
- Stop-loss orders mean a broker will buy or sell a security when it reaches a specific price, limiting how much an investor might lose on a position.
- A limit order yields a purchase or a sale of a security at a specific price or better.
- Another option is to buy a put option, which means the buyer has the right but not the requirement to sell a certain number of shares at a strike price.
Stop-Loss and Limit Orders
For example, assume you hold a long position in company XYZ. It is trading at $55, and you place a stop-loss order at $50. Your order will be entered once the price moves below $50, but this does not guarantee that you will be taken out at a price near $50. If XYZ's stock price gaps lower and opens at $40, your stop-loss order will turn into a market order and your position will be closed out near $40—rather than $50, as you had hoped. On the other hand, if you decided to enter a limit order to sell at $50 (instead of the stop-loss discussed above) and the stock opened the next day at $40, your limit order would not be filled and you would still hold the shares.
A gap is a technical occurrence in which a security's price spikes or drops at the start of trading versus the previous day's close, with no trading occurring in-between.
Mind the Gap
As you can see, if you are worried about a gap down in price, you may not want to rely on the standard stop-loss or limit order as protection. As an alternative, you can purchase a put option, which gives the purchaser the right but not the obligation to sell a specific number of shares at a predetermined strike price. The strike price is the price at which a derivative contract can be bought or sold.
Put options can be valuable when there is a depreciation of the underlying stock price in relation to the strike price.
Holding a put option is a good strategy for traders who are worried about losses from large gaps because a put option guarantees that you will be able to close the position at a certain price. However, they do come with certain challenges, most specifically costs associated with long-term protection against gaps and the ever-present issue of timing.
Ultimately, though, put options are probably the surest way to mitigate gap risk, although it requires a level of sophistication and experience to get the timing right. (See also: The Basics of Order Entry, Understanding Order Execution and Options Basics.)