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[dc]I[/dc] wrote this post about understanding and clearly defining your risk; Steven Place left a seemingly innocuous comment, “i’d love to see you delve more into managing gap risk on swing plays.” That sentence highlights one of the most serious challenges facing traders: How do you deal with an overnight price movement and an opening gap well beyond your intended risk point? Though there is no one-size-fits-all answer, I’d like to consider three questions today: why do markets gap open? What are the statistics around gap openings? Lastly, we will finish with some concrete ideas for trading around gap openings

Why do markets gap on the open?

Historically, overnight gaps were a fact of life  for traders in both futures and equities. Today, more and more markets are becoming essentially twenty four hour markets, so the first issue to consider is that your gap may not actually be a gap. For instance, it is very common (and silly) to hear stock traders talking about gaps in GLD, UUP, or some other ETF product. Just because it has three characters in the ticker and you can trade it in your equity account, does not mean it is a stock! These ETF products respond to overnight price movements in Asia and Europe; do not trivialize the trading of the other two-thirds of the world into an “opening gap” when futures will give a much clearer picture of the true market. It is my opinion that most traders should not be trading these products at all. Why are you trading twenty four hour markets using an instrument that gives you access to liquidity for less than seven hours a day? If you want to trade Gold or Silver, trade futures. If you want to trade UUP and FXE, then trade currencies.

However, if you are trading a legitimate product, ask yourself if the gap is market-driven or position-specific. For instance, if the S&P futures are up 20 handles before the equity markets open, you might reasonably expect to find many of your shorts gapped through their stops. You might trade those gaps differently than if you came in with the futures down 5 handles and found one of your biotech shorts (a topic for another day…) gapped 20% through your stop. Is your stock gapping in response to broad market news, sector news, or position-specific news, and how will that affect the choices you make? These are important questions to consider before you place your first trade.

Markets gap in response to new information. This, at a fundamental level, is what all markets do: they take information, process it, and, as quickly and efficiently as possible, incorporate it into the price discovery process. A gap, especially can indicate a powerful shift in market dynamics and psychology.

Statistics on gap openings.

It is not terribly difficult to do research on gap openings. (In fact, it is a good topic for the beginning researcher because it is fairly easy to set concrete parameters.) Though the statistics are somewhat different in futures and equities, there is a clear tendency in stocks: most gaps fail. Most gaps up will lead to selloffs and vice versa, but it is not easy to trade these because the “losing trades” can be large, volatility can be high, and liquidity low. Furthermore, the high or low of the day tends to be set shortly off the open. If a stock gaps up and continues to trade up, there is a very good chance that the low of the day has been set. To compound the problem, large gap openings can often trigger trend days, in which the market opens and closes near opposite extremes of the day’s range. Those are probably the key quantitative factors to keep in mind around gap openings:

• most gap openings fail and reverse, but, more importantly,
• gaps have a tendency to trigger outsized trend days in either direction.
• The action off the open is particularly important on gap days, because the high or low of the session tends to be set in early trading.

What do you do with that information?

Managing gap openings.

Let’s focus today on managing existing positions or entering swing trades on gap openings, ignoring the cases where traders specifically want to trade gaps as stand alone trades. (That’s a topic for another day.) First, assume that you want to enter a new position, but the market has gaped beyond your entry price. Depending on the trade setup, it may make sense to skip the trade; some very large gaps can invalidate some setups completely. Personally, many of my actual entries are quasi-breakout entries (though I would also argue I almost never trade pure breakouts… again, a topic for another day). If you are expecting to pay a breakout above $50.00 with a $45.00 stop, it can be very difficult psychologically to enter when the market is at $52.00 and your risk is 40% bigger… or is it?

No, there’s another way to think about this. This trade, in many cases, may actually be a better trade with the gap because the gap may indicate powerful forces driving the move. If you use the position sizing plan I laid out in this post, you will simply trade fewer shares. Even though the stop is now $7 instead of the original $5, the overall risk in the trade has not increased. This is an absolutely critical concept–please be sure you understand it. It may also make sense to massage the profit targets and trade management plan following these entries on gaps. For instance, if you enter that trade at $52 and the market trends down to close at $49, still well above your $45 stop, it often makes sense to simply get flat. (Note that this could be a failed breakout or a failure test at this point.)

However, most traders need to focus on what to do when a market gaps open well beyond the stop. You may come in in the morning and look at a loss that is three to four (or more) times your intended loss, perhaps even after the trade closed with a nice profit the day before. You better have a plan, and you better have it before this happens. These are ideas and approaches that have served me well over the years:

• Realize that this is an event that has the potential to compromise your emotional balance. Be careful to avoid anger, fear, or emotionally driven decisions.
• Realize that you are in a bad situation and it has the potential to get a lot worse. Fighting a single trend day on a gap against a position can wipe out an entire year’s profits. However bad the damage is on the open, more danger looms.
• Take action early on. The right answer in almost all cases is to get smaller.  (This mantra comes from Marty Schwartz, and is one of the few things I have had written beside my trading terminal for years.) Exit at least part of the position (25% to 50%) as soon as you can. Don’t mess around–push the button.
• Be clear that your job is not to salvage the trade. Do not add to the position and attempt to trade out of it. (Having written that, there are a very few cases where a commodities trader actually should add to a losing position on a gap opening. For 99.99% of traders and trades, this is a recipe for disaster as swings will now be magnified by larger positions in more volatile markets.) Your job is to manage the risk in a trade gone awry–don’t be a hero.
• Place a hard stop beyond the day’s extreme. For instance, if you were short and the market gapped up past your stop, you should have bought back 1/4 to 1/2 of your position. If the market then trades down from the open, place a stop above the high of the day for the remainder of the position. Congratulations, you have just limited the damage you can do to yourself. Most self-directed traders do not have the discipline to enter this order into the market and to respect it. Most self-directed traders lose.
• Do not add back what you have covered. Do not agonize if you could have gotten a better price by waiting. Yes, on some days this will be true. On the days it’s not true, you might have gone out of business. Again, understand your job (limit the damage) and don’t be a hero.
• Exit the remainder of the position as the day moves on. How and where you do this is up to you, but I would encourage you to remove yourself from the decision process as much as possible. Perhaps use a trailing stop (not a platform-specific trailing stop, but something like the Parabolic or a Chandelier Stop), or just enter a MOC exit order.
• In some small set of these, the gap failure will be dramatic enough that you will need to reenter the trade. If so, I usually think of it as a completely new trade.

Tomorrow I will show an example of these concepts at work in a recent trade in GMCR.