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Overnight Price (Gap) Risk

Dec 22, 2020

Overview

Stocks and stock options trade for a limited time each weekday, generally 9:30 am ET to 4:00 pm ET. There is also a pre-market trading session that starts as early as 4:00 am ET and a post-market trading session that goes as late as 8:00 pm ET, Monday through Friday. These pre and post-market sessions are for stock trading only. Stock options only trade during the regular market session.

When you hold a stock or stock options position overnight, there is a risk that the market can gap or jump a significant amount in price, up or down, on the open of the next session. This gap in price can either benefit your position or can cause a significant drop in account value.

Generally, these price movements occur when there is a major news announcement made about a company, like earnings, dividends, or other corporate actions. But it could also be a major international news event that will affect the entire market, taking most stocks along with it, higher or lower.

It is important to keep an eye on this overnight price risk concept as applied to a general overall account risk management plan. You should try and avoid situations where a large price move against your open positions wipes out a substantial portion of your account and knocks you out of the game. And although you cannot predict or anticipate these events, you can take a proactive approach that can help mitigate your overall exposure to this risk.

Beta Neutral Trading

One way of mitigating overnight price risk is by building a balanced ‘Beta’ neutral portfolio of positions, where some positions are long, and some are short. Long positions have a positive Beta to the overall market, and short positions have a negative Beta value. Beta is the amount as a percent that a stock moves in relation to the overall market. For example, if you have a position with a Beta of 1.25%, and the overall market goes up 1%, you would expect the position to go up 1.25%; and if the overall market goes down 2%, you would expect the position to go down by 2.50%.

Beta is a fundamental value that is available for most stock symbols. By summing up the position- weighted Betas for a portfolio of stock and stock options positions, you can measure the overall, long or short, exposure to the market. You should consider avoiding having all your eggs on one side of the basket. So, the closer you can get a portfolio to Beta zero, the lower the overnight directional price risk.

Overnight Price Potential

By looking at a historical daily price chart for a stock symbol, we can visually see those bars in the chart where the open of a new bar gapped up or down from the previous close. There is a technical indicator concept called ‘True Range’ that quantifies this opening gap amount on each daily bar. Figure 1 below is a daily chart with a custom indicator that calculates the highest true range over the past 30 daily bars. We can use this ‘True Range’ value as a proxy for estimating the overnight price potential risk for a stock or stock options position.

Let’s say we take the highest ‘True Range’ over the past 30 daily bars. We multiply it by 2, for a worst-case scenario, and then multiply it by the number of open position shares. The result is a pretty good estimate of the overnight / over weekend dollar price risk for that position.

Daily chart of AMD with a custom study “@MC Highest True Range.

Figure 1: Daily chart of AMD with a custom study “@MC Highest True Range.”

You can download the “Highest True Range” indicator and workspace for TradeStation 10 here:
https://ts-webinar-files.s3.us-east-2.amazonaws.com/%40MC+HighestTrueRange.zip

Let’s talk through an example. We are holding 200 shares of XYZ stock, and the highest true range for XYZ over the past 30 trading days is $10. If we multiply $10 times 2 (as a worst-case scenario), times the 200 shares we own, we get an overnight dollar risk potential of $4,000. ($10 X 2 X 200) = $4,000.

It is important to mention here that improper trade sizing or overtrading your account can exacerbate the overnight price risk – especially if you have too many big positions on one side of the market. Do some research on the concept of “Fixed Fractional’ trade sizing, which is a method that keeps trade risk consistent and appropriate for your account size.

Do I need a Futures Account?

Having a Futures trading account along with your equities account may give you a direct way of hedging or offsetting a position on the fly overnight if necessary. There are a number of major market futures that can be utilized for this purpose, including the CME Group’s S&P 500 or NASDAQ 100 E-mini and micro E-mini contracts.

Have you ever been watching the evening news as some big market event is happening, and you know that event is going to be bad for your stock or stock options position in the morning, but there is nothing you can do about it until the next morning and wait to see what happens? Or perhaps there is an international news event that creates a trading opportunity. But with only a stock account, you must wait until the market opens, and by then, everyone has seen that news and the market gaps way up or way down, and you possibly miss an opportunity.

With a futures account, you have the ability to mitigate overnight price action, by either hedging or closing a position, if needed.

Conclusion

Traders should find a balance between profit potential, trade risk, and overall account risk based on their personal investment objectives and risk tolerance. You cannot trade if you lose all your money. So, you should be knowledgeable and master the skills of account money management, starting with proper trade sizing on each trade and not having excessive exposure overnight to one side of the market.

Every pilot knows that taking off in an airplane is optional, but once airborne, landing safely is a necessity every time. Make sure that when you enter a trade, you know all the risks, what you will do if the market goes in your favor or goes against you, every time.

There is rarely a perfect hedge as a hedge may not always make up for all the losses of the actual position. And of course, if you feel the risk is just too high, the ultimate hedge is to close your position and come back to the markets the next day.

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