Gap risk refers to the potential for significant price changes between the Friday market close and the Monday market open, caused by events or news over the weekend when trading is paused. These price gaps can lead to unexpected profits or losses, especially in highly leveraged positions. Managing gap risk effectively is crucial for traders aiming to minimise adverse impacts on their portfolios.

Understanding gap risk

Gaps occur when the market opens at a significantly different price from where it closed. These price movements are driven by news, economic data, geopolitical developments, or unexpected events over the weekend. In forex, stocks, and commodities, these gaps can vary in size depending on the market’s volatility and the significance of the weekend event.

Strategies to manage gap risks

1. Reduce or close open positions before the weekend

• Evaluate your open trades on Friday and close those that are exposed to potential weekend events.
• This approach eliminates exposure to large price swings.

2. Adjust position sizes

• Reduce the size of open positions to limit potential losses if a gap occurs.
• Smaller position sizes reduce the financial impact of adverse price movements.

3. Use stop-loss orders cautiously

• Place stop-loss orders to limit potential losses, but be aware that stop losses may execute at a worse price (slippage) if the market gaps significantly.
• Consider wide stop-loss levels or hedging as an alternative.

4. Hedge your positions

• Use correlated assets or instruments to hedge open positions.
• For example, a long EUR/USD position could be partially hedged with a short EUR/GBP position.

5. Monitor weekend risk events

• Identify key events scheduled over the weekend, such as elections, geopolitical developments, or economic summits.
• Avoid holding positions in assets likely to be directly impacted by these events.

6. Trade lower-volatility instruments

• Focus on instruments or currency pairs less prone to gaps, such as those not affected by major weekend news.
• Exotic pairs or smaller markets may have higher gap risks.

7. Diversify your portfolio

• Spread your risk across multiple trades and asset classes.
• Diversification helps mitigate the impact of a gap in any single market.

8. Use options for protection

• Buy options to cap potential losses or lock in profits.
• For example, a forex trader might buy a put option to hedge a long position over the weekend.

9. Set conservative leverage levels

• High leverage magnifies the impact of gap risks. Use lower leverage ratios to reduce potential losses.
• Ensure your account can handle potential margin calls if a gap occurs.

10. Be prepared for slippage

• Understand that stop orders might not execute at the exact price set due to market gaps.
• Account for potential slippage when planning trades and setting risk limits.

Best practices for gap risk management

• Plan trades with the weekend in mind: Evaluate whether holding a position over the weekend aligns with your risk tolerance and market outlook.
• Use fundamental analysis: Assess the likelihood of significant weekend events impacting your positions.
• Review historical data: Analyse past gap behaviours in the assets you trade to understand potential scenarios.
• Stay informed: Keep track of news and announcements that could influence markets over the weekend.

Common weekend gap scenarios

• Geopolitical events: Elections, military conflicts, or unexpected political developments often lead to large gaps.
• Economic announcements: Unexpected data releases or policy decisions during international summits can trigger market movements.
• Natural disasters: Events like earthquakes or hurricanes can impact commodity prices or specific currencies.
• Corporate news: Earnings announcements or significant developments can create gaps in stock prices.

FAQs

What is gap risk in trading?
Gap risk is the possibility of a significant price movement between market close on Friday and open on Monday, resulting from news or events during the weekend.

Why do gaps occur?
Gaps occur because markets are closed over the weekend, and traders cannot react to events until they reopen.

How can I minimise gap risk?
You can minimise gap risk by reducing position sizes, closing trades before the weekend, hedging, or trading instruments with lower volatility.

Do stop-loss orders work during market gaps?
Stop-loss orders may execute at a worse price than expected due to slippage, especially during significant gaps.

What instruments are most affected by gaps?
Highly volatile assets, such as forex pairs linked to news-driven economies or stocks tied to corporate announcements, are most affected.

Should I trade during gaps?
Trading during gaps can be risky due to unpredictable price movements and limited liquidity.

How can I hedge gap risk?
Hedging gap risk can involve using options, correlated trades, or offsetting positions to mitigate exposure.

Can I profit from gaps?
Yes, traders who anticipate gaps correctly can profit from significant price movements by positioning before the market closes.

Are gaps more common in certain markets?
Yes, gaps are more frequent in forex, stocks, and commodities affected by weekend news, while some markets, like cryptocurrencies, trade continuously.

What role does leverage play in gap risk?
Leverage magnifies the impact of gaps, potentially leading to significant losses or margin calls if not managed carefully.

Conclusion

Managing gap risks between Friday close and Monday open is essential for protecting your trading capital. By reducing exposure, using hedging strategies, and staying informed about weekend events, traders can minimise potential losses and navigate gaps effectively. A disciplined approach to weekend trading can help balance risks and opportunities in volatile markets.