Overnight Gaps and Trend Trading

Overnight Gaps and Trend Trading

Overnight risk refers to the risks of what happens to the markets while you sleep or while the stock exchanges are closed and you cannot exit your positions. During this time, your money is exposed, and if you are trading on margin, you are exposed to a margin call.
Some markets, such as forex, trade around the clock, so the nature of overnight risks is different. However, even forex closes for the weekend, which is when you are exposed to dramatic market moves.
You can place a stop loss order to help reduce your risk. Placing such an order is as simple as executing any other order through the order execution software provided by your broker. Then if your position moves against you to a certain level that you specify, the broker will close your position.
However, if the exchange is closed, it is possible for the market to break through your stop loss order, and your position will not be closed at the price you specified in your stop loss order.
For example, if you buy a stock at $20 and place a stop loss order with your broker to sell at $18, your position will typically close at or near $18 when the stock reaches that price. You can place this stop loss order if you want to risk trading up to $2 per share.
But the next morning, you could find that due to some disastrous event, the stock opens at $5! In such a case, your stop loss order will not be executed at $18, giving you a loss of $2 per share, but instead will be filled with around $5 per share, so you will now have a loss of $15 per share!

Even then, your order may or may not be executed depending on whether your stop loss order is a limit order or a market order:

  • A limit stop order is where you set the price range at the point you wish to execute the trade. For example, if you place a limit order to sell between $17.50 and $18 and the market gaps the next morning, you will not be taken out of your position because the stock has crossed the upper limit or lower range of the order.

You wouldn’t sell the stock at a low price you might not want to accept (like $5), but your loss – called an unrealized loss because you didn’t sell your stock and lock up your loss (because your stock position is still open and the price can go up or down before selling) – It is still very real in the sense that it has reduced your overall wealth.

  • Unless specified as a Stop-Limit order, a normal stop order is a market order, where your order is executed after the market reaches the price you specify; However, you do not have any guarantees as to the price at which your order will be executed. For example, the next morning, you are taken out of your position by about $5, thus maintaining a loss of $15 per share.

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