Gap Risk

What Is Gap Risk?

Gap risk is the risk that a stock's price will fall dramatically from one trade to the next. A gap occurs when a security’s price changes from one level to another (up or down) without any trading in between. Usually, such movements occur when there are adverse news announcements made about the company, which can cause a stock price to drop substantially from the previous day's closing price.

Understanding Gap Risk

A gap is a discontinuity in a security's price, often developing when markets are closed. Gaps can occur when a piece of news or an event occurs after regular market trading hours and results in the opening price being significantly higher or lower than the previous day’s closing price.

Gap risk is the chance of being caught by such a gap. Gap risk is traditionally associated with equities because the stock market closes overnight and news cannot be factored into the price during those hours. The risk of a gap increases the longer the markets are closed.

Investors who hold positions over the weekend, and especially long holiday weekends, should be especially cautious. Gap risk is reduced in the forex market because it trades 24 hours a day, often seven days a week.

Example of Gap Risk

Suppose that a stock's price closes at $50. It opens the following trading day at $40 even though no intervening trades have happened between these two times.

Gaps can also occur to the upside. Imagine you are a short-seller in XYZ stock. It closes the day at $50. Due to a positive earnings surprise, the stock opens at $55 the next day.

Managing Gap Risk

Swing traders can minimize their gap risk by not trading or closing open positions before a company reports its earnings. For example, if a trader is holding an open, long-position in Alcoa Corporation (AA) the day before the company reports its first-quarter earnings, that trader would sell their holdings before the close to avoid any gap risk. Earnings season for U.S. stocks typically begins one or two weeks after the last month of each quarter. Investors can monitor upcoming earnings announcements through a website like Yahoo Finance.

Investors need to be mindful of gap risk when determining their position size for trades that they hold longer than one day. Even if a trader determines their position size by risking a certain percentage of their trading capital to each trade, a gap in price can result in a significantly greater loss being realized. To combat this, investors might half their position size ahead of any expected volatility. For example, if a trader intends to hold a swing trade during a week the Federal Reserve makes an interest rate decision, he could reduce his risk per trade from 2% to 1% of his trading capital.

Investors can also offset gap risk by using higher risk-reward ratios. For example, an investor uses a 5:1 risk/reward ratio. If that risk doubles as a result of a gap, the ratio becomes 2.5:1, which provides a positive expectancy if the trading strategy has a win rate of over 29%.

Investors can use various hedging techniques to help manage gap risk. Investors can buy put options, inverse exchange-traded funds (ETFs) or short sell a highly correlated security (if they are holding a long position) to hedge against any gap risk. For example, if an investor has purchased 1,000 shares of Bank of America Corp. (BAC), he could hedge against any gap risk by also buying 100 units of the Direxion Daily Financial Bear 3X (FAZ) ETF.