Financial markets are not generally open continually. Cryptocurrency markets by contrast, are open all the time. If you want to trade Bitcoin over the weekend you can. There are also various weekend markets on some smaller platforms, where you can speculate on assets like Dow Jones. If a market is closed and a big market moving event occurs during that period, the price will gap, and indeed this weekend has seen a prime example, where Erdogan’s sacking of the governor of the Turkish central bank governor.
However, even during market hours we can face some element of gap risk, such as when news hits the wires or in the various flash crashes over the years. How can we quantify gap risk? After all, if we want to get out of a position we need to have a rough of idea of how much we could lose in a gapping situation if we were to put a stop loss order for example.
There many simple ways to look at this we can start to get a handle on this. We can plot the distribution of the gap between closes and opens as a start, which can cover out-of-hours events. We can also look at the distribution of the intraday range of price action. We can repeat the analysis for specific events where there could be gap risk, such as central bank meetings which are scheduled, or other regular events which aren’t (sacking central bank governors isn’t a one off event, although the timing is not!). The difficult is that some events are very rare, so it can be difficult to make generalisations about them. However, even if there’s one or two historical precedents, that is still going to provide some information, even if that is never going to be a rigorous backtest!
Is there a way to cap gap risk at a specific level? If we are willing to manage our risk through options, we can at least cap our loss, if we are long options. This doesn’t mean we should always take directional risk through options, indeed I recently wrote about the pros and cons of taking directional risk through options.
If we’re trading cash, we’ll face gap risk. Like any sort of risk, it’s always a good idea to understand it’s size and how it can impact P&L. Looking at historical data can at least give us a rough idea of how bad it could be for common events. Obviously for truly one off events it can be a lot more challenging to quantify gap risk, such as the SNB removing the EUR/CHF floor.