Volatility and Risk

The market is experiencing increased volatility, best demonstrated by the VIX’s 50% jump from 22 to 33 the last week. Such volatility can bring some particular risks to investors.

With the influx of trading in more speculative names together with the market volatility, many analysts and market experts believe a perfect storm is potentially brewing.

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.

These risks generally appear together, and often after periods of excessive growth in a security which has been stretched beyond its normal trading range, such as short squeezes (Volkswagen in 2008), flash crashes (US markets 2010) and euphoria bubbles (Kodak in 2020 & Nintendo in 2016).

So remember to take this into consideration when trading highly speculative and topical names as history can tend to repeat itself.

Mind the gap

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 $5. Overnight, news comes out which causes the stock to spike. The next morning, it opens at $7. While the price jumped 40%, it did not trade at any price between $5 and $7. This is known as a ‘gap up’. The same works inversely when stocks ‘gap down’ 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 fulfillment. Tesla may be trading at $800 at close before its earnings report. You have a stop loss at $770. Following a negative report, the stock gaps down and opens the next session at $750. Your stop loss will be filled at $750 as the stock did not trade between these points.

In periods of increased volatility, gaps are more likely to occur.

All dried up

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.

Being aware of liquidity is important for 2 reasons:

1. 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.
2. In particularly illiquid names, a large spread between 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.

In July 2020, Eastman Kodak jumped 1500% in 2 days on the back of vaccine manufacturing reports. This saw a massive influx of volume on the way up and then relatively low volume traded as the stock fell back towards its lows. This journey included a 15% and 40% gap down in the week following its high.

We hope this information was helpful.