What is Gap Risk
Gap risk refers to a security’s price changing from one level to another with no trading in between. Usually, such movements occur when there are adverse news announcements, which can cause a stock price to drop substantially from the previous day's closing price.
BREAKING DOWN Gap Risk
Gap risk is the chance that a stock's price closes at $50 and opens the following trading day at $40 — even though no trades happen between these two times. Gap risk is traditionally associated with equities due to the stock market closing overnight; this does not allow news to be factored in during those hours. Gap risk is reduced in the forex market as it trades 24 hours a day, five days a week. Caution, therefore, must be taken by investors who hold positions over the weekend.
Managing Gap Risk
- Earnings: Swing traders can minimize gapping 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 Corp. the day before the company reports its first-quarter earnings, the trader would sell his holdings before the close to avoid gapping 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 Yahoo Finance.
- Position sizing: 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 her position size by risking a certain percentage of her 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 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.
- Risk/Reward ratio: Investors can offset gap risk by using higher risk/reward ratios. For instance, suppose an investor uses a 5:1 risk/reward ratio. If that risk doubles due to a security gapping, the ratio becomes 2.5:1, which provides a positive expectancy if the trading strategy has a win rate of over 29%.
- Hedge: Using various hedging techniques can help manage gap risk. Investors can buy put options, inverse exchange-traded funds (ETFs) or short (if holding a long position) a highly correlated security to hedge against gap risk. For example, if an investor has purchased 1,000 shares of Bank of America Corp., he could hedge against gap risk by also buying 100 units of the Direxion Financial Bear 3X ETF. (For more, see: A Beginners Guide to Hedging.)