Gap Up/Down Risk-- How to Manage It

Discussion in 'Strategy Building' started by Corso482, Feb 17, 2004.

  1. With my swing trading strategy, my biggest problem are gaps...they completely screw up my risk control. Well, I´ve mitigated gap risk somewhat by never putting more than 10% of my capital in any one position, i.e. if a position gaps against me 50%, my total capital only took a 5% hit.

    So I was thinking...if I were to divide up my capital even more, say in half, and put 5% of my money in each position, would I really be cutting down my gap risk? Gaps would hurt half as bad, but I´d be carrying twice as many positions. Wouldn´t that make me twice as likely to catch a gap?

    Any ideas?
  2. Welcome, I have the same problem. I was thinking that we need a product similar to a Put that covers only overnight gaps. (one-night-put)
    So, at the end of the day, you pay a small premium and assure that your position is safe and you can sleep deep.
    The current bid/ask spreads of options are prohibitive, so there is no solution than to exit the position on Close.
  3. JanP


    In my swing trade experience, gap downs are usually balanced out by gaps up. Or, if you are short (I assume you trade both long and short), then vice versa. And, of course, gaps work in your favor sometimes.

    When you put on the trade, you don't know if it will gap tomorrow, the next day, or at all. So, why worry about it and adjust your position size as you suggested? Better, in my opinion, to tighten stops as you go. So, let's say your planned maximum amount to risk is a hypothetical 5% and let's say you are able to shrink this percentage (move your stops up) as the trade moves in your favor. Over time, over many trades, your planned 5% risk will be significantly less. So, an occasional gap past your 5% stop won't matter much when averaged over many trades.

    As far as position sizing, don't factor in gaps (they'll work out over several trades as I said). Instead, simply determine your per trade risk (e.g. 5%), how much of your total portfolio you are willing to risk per trade (e.g. 1%), and how much total portfolio risk (portfolio heat) you are willing to have at one time (e.g. 10%) and do the math to determine how many shares to buy and how many positions to take.

    And, by doing the above, you could factor in a little gap space (if you are using some method other than a set %), and your trades will be just a little smaller.

    Hope that helps.

    Jan P.
  4. Gaps are a fact of life in overnight holds. Anything you do along the lines of options, single-stock futures, pairs/spread may reduce your risk, but will decrease your profits (some gaps help) and increase your costs.

    To minimize the affect of gaps;
    1) Keep position size small relative to the overall size of your equity.
    2) Set limits on the amount of exposure in one direction based on your risk tolerance. For example, you might limit your long positions to 100% of equity, allowing margin only for short positions (a market hedge rather than stock-specific though). You can use a static percentage or adjust it with your market bias or risk assessment.
    3) Limit positions to one per sector, unless somehow you find an opposite position in another stock in that sector (unlikely).
    4) Stay away from scheduled earnings announcements or conference calls, unless your strategy calls for these plays.
    5) Limit your holding time with time stops. Don't let the trade drag on.
  5. If you intraday trade continously using an optimum fractal, then at the end of the day go to the overnight fractal to sweep funds into the current trend account.

    An ES example. Friday was trading in a "long" intermediate term (IT) trade for this quarter's front quarter. Any quarter has up to 1o to 12 of these IT trends.

    Contracts for the period from before close to the opening synch period (where you exit to get ready for the intraday Tuesday trading) contained the profits you make from the IT trend that continued through the overnight (weekend and Holiday in this case). Personally, I did my L16 trade beginning at 16:13 and ending at 9:35 plus. the run was from 45.2 to 54.1 of just under 9 points per contract. L stands for long and 16 stands for the number of the action. C17 was the ID of the cover.

    If you are not used to segmented accounts for trading several fractals concurrently, then is it best to just run your account serially by doing the intraday beginning after synch each am and ending very near close and then resuming the IT trend trade over night. It is not good to hold the over night during the synch the next am but instead just cover at the best value attained in the synch bars (bars 1 through 3 on 5 min chart).

    The pair of efforts gives a good yield. You may find it occasionally disconcerting to make more money overnight than you do during the intraday. The example of this weekend made 20% of margin/contract; SCT trading did 15 trades the prior Friday and would approach a multiple of the H/L in the am and in the pm.

    There is a gap covering myth that some people adhere to. If that were true, you would have the potential of picking up another 9 points after the open. This is an important reason for covering the overnight immediately if you believe that. On the other hand, you may recognize that a different fractal is required during the day for your primary money making. by registering 20% of margin/contract as you day's starting point, it keeps you focused on the IT trend that is the envelope of today's trading. Because your chart squash this advance to a gap, you simply transpose the IT trend channel to the new day and use it as a guide for making money just as the weekend trade did for you.

    Luckily you have this opportunity almost every evening. Accumulating profits from over night gaps in this way is a real helper for appreciating capital rapidly and it takes little work on anyone's part.
  6. kc11415


    I have what is probably a naive question, and there are probably problems that I'm not aware of...

    As a slightly different example from the original interday question, suppose there's an instrument I'd like to trade intraday because I like some of the trading characteristics. However, further suppose it has a combination of volatility and leverage in which the fat tails of the distribution exceed my risk management guidelines. Suppose I'd like to trade the "normal" volatility within about one standard deviation but I really don't want to expose myself to deviations outside that range. That means I'd be giving up the potential huge upside for the sake of eliminating huge potential downside.

    If my intraday trading of the underlying was always long positions, I could just hedge with a put, and vice versa with a call if I only did short positions. If I want the ability to take either a long or short position, then how about buying a front-month straddle or strangle centered somewhere around the current trading range of the underlying?

    What am I forgetting if I assume the costs I pay for this insurance include:
    *) spreads on each option in the hedge
    *) commissions on each option in the hedge
    *) time decay for the period I hold the hedge
    *) any reduction in implied volatility during time I hold the hedge.
    These costs would offset the profits from my trades, but these costs would be amortized across all trades done while that hedge was held.

    Assuming just intraday trading, with being flat at the end of the night, something to consider is whether to hold the hedge overnight, with the following considerations:
    1)Holding the hedge overnight gives exposure to time decay and implied volatility declining.
    2)However, holding the hedge overnight also eliminates paying the spreads & R/T commissions each and every day.
    3)Also, holding the hedge overnight gives the straddle some time to possibly work its way a bit more in my direction if there happened to be a gap.
    Now, #1 & #3 are both uncertain but might offset each other. #2 is mostly certain (spreads might vary a bit) and favors holding the hedge through the flat times (i.e. overnight).

    Does anyone know if any brokers or exchanges will allow such options hedges to offset margin required for a futures position? Or, would I be forced to liquidate my hedge if I need to raise funds for a margin call on the underlying?

    I realize I'm probably making some false assumptions here, but I'd be grateful for any who would set me straight.