Understanding market risks
The market is experiencing increased volatility at the time of writing.
The piece below brings your attention to ‘gap risk’ and ‘liquidity risk’, two factors to consider while managing your portfolio during such periods.
Whatever your position or strategy, we want to make sure you’re informed and understand the risks and can add them to your knowledge base when tackling the markets. Trending stocks change all the time, so it’s best that you know what you’re getting into before diving in.
Understanding gap risk
It is not uncommon for stocks to gap across price ranges, especially between market close and the following market open. Let’s use an example. A stock closes at $15. Overnight, news comes out which causes the stock to fall. The next morning, it opens at $12. While the price fell 20%, it did not trade at any price between $15 and $12. This is known as a ‘gap down’. The same works inversely when stocks gap up in price.
This is also possible in intraday trading, especially as stocks come out of trading halts.
It is important to be aware of such price action as it has an effect on order fulfilment. A stock may be trading at $50 at the close of a session. You have a stop loss at $45. Following a gap down before the open, the stock gaps down and opens the next session at $43. Your stop loss will be filled at $43 as the stock did not trade between these points.
In periods of increased volatility, gaps are more likely to occur
Understanding liquidity risk
Even if a stock traded at a particular price, it doesn’t necessarily mean every order for that price would be filled. A highly liquid stock will have a large volume of shares trading at different prices, and a small spread between the bid and ask. An illiquid stock has few shares traded at different prices and a large gap between the bid and ask.
- A stock may have crossed through your order price but there wasn’t enough liquidity to accommodate your order completely. For example, a stop loss may execute at an average price below your specified stop, even if the stock price hit your stop price. Or on the flip side, a limit sale may not completely fill even if the price reaches your specified limit.
- With particularly illiquid stocks, a large spread between the bid and ask may make it difficult to buy or sell at your target price.
Liquidity can also come in and out of a stock very quickly, especially more volatile ones. For example, if a highly traded stock starts to dip and buyers stop coming into the market, it may become difficult to sell out of positions.
Such volatility can bring some particular risks to investors, this may include trading halts. We have prepared the following piece to bring your attention to different types of trading that may occur during periods of volatility.