Manyare hesitant to invest in the stock market because of the large gaps in prices. It is notuncommon 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 thatinvestors 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.
Key Takeaways
- 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.
Understanding Price Gaps
Price gaps, those noticeable disparities between the closing and opening prices of an asset in consecutive trading sessions, arise due to various factors. Sometimes, it may be external influences or unforeseen triggers. Other times, it's caused by shifts in market sentiment or a bad news release. The causes behind price gaps are diverse, encompassing everything from economic indicators and corporate earnings reports to geopolitical events and unexpected market news.
Common gaps depict a price jump reflecting the natural ebb and flow of the market. There are other types of price gaps, though. Breakaway gaps signify the onset of a new trend, usually emerging after a consolidation period that aren't going to be talked about in this article as it usually indicates a gap up. Runaway gaps indicate a continuity of an existing trend, highlighting sustained momentum. Exhaustion gaps uggest a potential reversal in the current trend.
This array of price gaps enables traders to shape informed strategies that anticipate and adeptly respond to market shifts. However, it may not always be possible to prevent a gap down that occurs after hours.
Stop-Loss Orders
A stop-loss order is placed with a broker to automatically sell a security when it reaches or falls below a specified price level, known as the stop price. When an investor places a stop-loss order, they are essentially setting a safety net for their investment. If the market price of the stock drops to or below the pre-determined stop price, the stop-loss order is triggered, and the stock is automatically sold at the best available market price.
The primary benefit of a stop-loss order is its ability to provide downside protection, allowing investors to set predefined exit points and manage risk effectively. However, it's crucial for investors to consider the potential for market volatility and price gaps, which could result in the execution of the stop-loss order at a different price than the specified stop price. Stop-loss orders are not foolproof and may not work as intended in certain market conditions, such as during fast market movements or in low liquidity situations. Let's take a look at a short 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.
The SEC is transparent about certain risks that occur during after-hours.
Limit Orders
A limit order is an instruction to buy or sell an asset at a specified price or better. The primary purpose of limit orders is to capitalize on favorable pricing, enabling traders to enter a position at a more advantageous cost or exit at a profit. Unlike market orders that execute immediately at the prevailing market price, limit orders provide a level of control over the execution price, allowing traders to set specific entry or exit points.
When a trader places a buy limit order, the order is executed at the specified limit price or lower. Conversely, a sell limit order is executed at the limit price or higher. This means that the trade will only be executed at the desired price or a better one.
Let's take a look at a quick example. 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. Put options are the surest way to eliminate gap risk, although it does come at a premium. Ultimately, it’s up to you to determine if the benefits outweigh the cost.
What Is the Significance of Protecting Against Gaps in Trading?
Protecting against gaps is crucial to mitigate the risk of substantial price disparities, ensuring a secure trading strategy. Gaps result from unexpected events, and protective measures, like stop or limit orders, help manage potential losses.
Why Are Price Gaps Considered High-Risk Scenarios in Financial Markets?
Price gaps are deemed high-risk due to their potential to cause rapid and significant price movements. Triggered by external factors, market sentiment shifts, or unexpected events, gaps can lead to increased volatility and pose challenges for traders.
What Limitations Should Traders Be Aware of When Using Stop Orders Against Gaps?
Despite benefits, stop orders have limitations including potential slippage in low liquidity or after-hours trading. Your stop order may turn into a market order depending on the price of your order and gap.
How Can Investors Navigate Overnight and Weekend Gaps Using Order Strategies?
Investors can use a combination of stop orders, limit orders, or GTC (good 'til canceled) orders to hedge against some price action. Investors should also stay informed on global events, company news, industry updates, and other internal or external items that may quickly change a security's price.
The Bottom Line
Investors often shy away from stock market investments due to significant price gaps, where a stock can open substantially lower than its previous close. While strategies like stop-loss or limit orders are commonly used to mitigate gap impacts, the inherent risk of market volatility persists and you may not always be protected when using either type of order.
