Mind the gap! Strategies to managing ‘gapping’ risk with Shares and Share CFDs

Obviously, one of the major differences between trading shares or share market derivatives (e.g. Share CFDs and Options) compared to other instruments such as Forex and Index or Commodity CFDs, is the daily set market hours and the risk of potentially significant differences in price between the close of one trading session and the opening of the next.

GO Markets offer the opportunity to trade both Share CFDs on the Australian and US equity markets on your MT5 platform.  For reference, those of you that are new to this as a trading vehicle,  the ASX opens from 10am to 4pm Australian Eastern time, whereas the US equity markets open from 9.30am through to 4.00pm US EST.

Why gapping occurs

Focusing on the ASX as an example, there are many events and economic announcements than can occur in the 18 hour “gap” between close on one day and open the next, as well as often the Australian markets responding to what has happened in the US “overnight”. This additional information is what creates the “gap”.

You will already have in your plan the need to be especially cautious prior to earnings release (or similar) for any companies due to report. Such releases commonly occur outside of market trading hours. This, more than any other situation, can create major ‘gapping’. Recognising this is the case, many traders avoid entering trades in companies where this is imminent. Hence the inclusion of finding this out prior to entering any trade as part of your plan seems logical as part of your risk management.

So, what can you do?

Although we cannot predict what will happen there are potentially “clues” that can be tested and may help in decision making relating to the market risk, (and so potential for major gapping). Remember these are “clues” only particularly relevant to short-term share CFD trading (and may be less of an issue for those intending to hold for the long-term).

Such “clues” may help you make decisions on:

• Which direction to trade (e.g. long or short entry opportunities)
• Position-sizing approaches (e.g. if there are major announcements one may choose to enter smaller sized trades

For efficiency in terms of your time, it could be argued that this “daily ritual” should be performed prior to looking at specific stock charts at the start of any trading day.

Here are five clues that you may choose to consider:

1. ASX trend including closing candle (daily chart)

Experienced traders generally support the concept of trading with the trend as a common approach. Also, the closing price of the day is also thought to be the most important in terms of the buyer/seller “battle”.

Bear in mind also, that by its nature, a movement in the overall index reflects the sentiment towards the shares that comprise it

If you accept that this is an approach that you wish to employ in your trading, then logically you should only consider a “long trade” when the overall market is in uptrend and short trades when in downtrend. Additionally, it is generally accepted that a close in the top third of a candle is more likely to see follow through than if towards the bottom of the candle.

2. US trend and futures direction and degree of potential movement (Daily chart US500)

If one subscribes to the idea that the ASX will commonly reflect the performance of US markets, then there are already “clues” as to what may happen through looking at the US futures. Although these can and usually do change as more information is released, again logically, you need to ask the question as to whether trading against what the futures are telling you could happen is worth integrating into your trading plan.

For example, this could look like “If I am looking at a long trade on the ASX, I will position size half of the level which I would normally do, if US futures are down in excess of 0.3%”.

3. The VIX index trend

The VIX index (sometimes termed the “fear index”) reflects implied volatility of options (so is forward looking). It is commonly recognised that there is an inverse relationship between movement in the VIX and the S&P500. Hence, a movement up in the VIX could be interpreted as an indication the market is getting “anxious” and so there may be a sell off (and visa versa).

Some have also suggested that on some occasions you may see a movement in the VIX prior to the market move. Whether this is the case or not in reality is up to your judgement.

Again, you need to make a choice as to whether to integrate this into your risk assessment of the market as a whole and articulate in your trading plan accordingly.

4. Economic data

As with other trading instruments you will already be familiar with the fact that short term market sentiment may change with the new information, or expectations, from major economic data.

Remember equity markets may respond differently in terms of both relevance and volatility to other instruments e.g., a perceived increased likelihood of an interest rate cut for example following a stronger than expected employment report will be bullish for equity markets but negative for the relevant currency.

Also, there may be economic data normally of low impact to Forex but may impact on specific sector shares significantly e.g. New home sales figures may create little disturbance to currencies in comparison to other data points but may have a significant impact on home building companies.

5. Specific sector information

An obvious example of this would be that every Wednesday morning in the US the EIA release oil inventory figures showing either a draw-down or increase in supply. If this moves from that which was expected, then there may be a noticeable move in oil price. So, logically it makes sense to exercise more caution if considering an energy stock CFD on a Wednesday in trading on the ASX.

In summary…

As is the case always, effective risk management is a critical cornerstone to achieving positive trading outcomes.

Risk management interventions may be either to consider whether not only to enter a position (or exit an open one), but also the size of the position you choose to enter.

Although, we are not aiming to be prescriptive, after all it is you who make the choices in ALL your trading decisions.  We have discussed some things for your consideration in managing the “gap” with share CFDs.  It is now over to you, to make decisions as to what is right for you, and of course to articulate this within your own trading plan.

Please drop an email with any questions or comments related to the session to mike.smith@gomarkets.com

Mike Smith

Educator

GO Markets

Disclaimer

The article from GO Markets analysts is based on their independent analysis. Views expressed are of their own and of a ‘general’ nature. Advice (if any) are not based on the reader’s personal objectives, financial situation or needs. Readers should, therefore, consider how appropriate the advice (if any) is to their objectives, financial situation and needs, before acting on the advice.