Price Gaps: How not to blow up your account

Trading on eToro platform has never been so easy. A clear user-friendly interface makes opening, monitoring and closing down trades very easy even for less experienced users. There are also plenty of learning opportunities and possibilities to practice on a demo account before risking your real capital. Yet, some trading technicalities and particularities in which financial markets operate may put your investment journey in danger.

Sometimes to your own surprise you might find yourself in a situation in which you are, for example, placing a buy position with a stop-loss level for protection yet somehow the trade falls right straight through it, so you end up losing much more than you were ever prepared to. Why does this happen? Because of an unfortunate market situation known as a market gap or a gap down, as it is in this case.

(NOTE: Before we continue, we have to give a disclaimer that the trading products offered by the companies listed on this website carry a high level of risk and can result in the loss of all your funds. CFDs are complicated instruments that are never guaranteed to provide you supplemental earnings.  In fact, Around 67% of all retail investors experienced a loss while trading CFDs. Make sure to keep this in mind before attempting to use the eToro platform yourself. All the information found on this website is not official trading advice and all practices shown are referenced for the use of the Demo account only.)

What is Price Gapping?

A price gap happens when the price of an asset is different (so above or below) from the closing price of the previous trading day. Basically, a price gap is a discontinuity in a stock’s price chart. If a stock closed with a price of $101 yesterday and the next day is starts trading at $99, there is a gap down happening. Gapping can be partial when the price at which the asset opens is above or below the previous day’s closing price but is still within the range of previous day’s prices. A full hap happens when this new opening price is completely outside of the range of prices of the previous day; it therefore shows a very strong change in market sentiments that happened outside of the market trading hours.

Price gapping on your eToro account

But let’s consider how this could happen in practice to make things more simple. Suppose you want to buy a few stocks of Apple i.e. go long in this stock, for a total monetary amout of $100. Although the price of Apple stocks might be much higher, this trade is possible because eToro allows you to trade with only fractions of shares. You always have an option to use leverage to amplify the size of your trade and so you choose the maximum level of leverage allowed for this asset type, which is x5. Now to protect yourself in case things don’t go as hoped for and the asset decreases in price, we set a certain level of stop-loss. This automatic trigger will close down your trade when it reaches a certain level of loss. Given your degree of risk aversion and the limited available capital, the maximum loss you can take on in this trade is $20. So if the value of this position will ever go down below $80, it will be automatically closed down by the platform and those remaining $80 will be returned to your available balance. The trade placed will then look like the image below.

Now, you are hoping to make some money on this stock (or part of it) over time, so you leave it overnight and come to check up on it the next day. Suddenly, your portfolio is empty and the position is not there. Why did this happen? Perhaps the stop-loss was triggered and now those remaining $80 are back in your account? Instead you might discover that you haven’t lost $20 but instead as much as $40 or $60 when your trade was closed ! Why did that happen? Is eToro a scam and stop-losses don’t work ? The answer is no of course and instead you found yourself in this situaiton because of market phenomena called price gapping.

First thing to understand the entire process is that markets are not open all the time. Apple is traded on NASDAQ, USA-based exchange, which closes and opens at certain hours only, like any other business. When you trade Apple stocks (or stocks of any company registered on this exchange) you can actually only do so when this exchange its open, during its working hours. But that is not the only time trading can occur, as you might have placed your trade during hours it was closed. Before and after markets like NASDAQ are open (or in technical terms, pre-market and after-market hours) there are still traders who can trade Apple stocks and consequently move its prices. Why can’t anyone do so? Well, it is only a very limited number of brokers that allow their investors to trade on these outside market hours and eToro provides trading opportunities within market hours only. In fact, trading outside market hours can be very risky and volatile and these trades are completed on electronic communication networks (ECN) outside the usual stock exchanges. Such orders tend to face higher liquidity risks, wider spreads and rapidly changing prices.

After you completed your trade while the market was open, some terrible news come out on Apple in the evening, for example a fraud scandal or an unpromising earnings report is released and investors massively lose their trust in the company. After market investors that no longer believe in the company start selling its shares in large volumes. Consequently, because of the increased supply of these stocks on the market the price goes down, by the basic economic law of supply and demand. What you see for your trade on the platform though is the old latest price the asset was traded at when NASDAQ closed the day before. So the price shall remain the same and it will only be updated on eToro feed when the markets open the following day. So despite the markets being closed at the time the price is actually decreasing. Despite the after market trading has caused several up and down changes in price after NASDAQ was closed at 16.00, as shown below,

the price on eToro shows the closing price and does not reflect these outside market hours changes yet and stays at yesterday’s closing level.

What we can see is that actually the real price at the moment right now is different from its yesterday closing price and although the price is changing in real time the price that you see on the platform is the same. The next day when the markets open the price that Apple will be trading at on eToro is going to change and it will finally reflect the actual price that accounted for the effects of trading that happened after the market closed yesterday and before it re-opened today. Many times these changes are relatively minor (as in the example above) and could even be profitable for you.

But lets get back to our unfortunate $100 trade. Now the stop-loss level you have set for your trade is linked directly to the real-time price from NASDAQ, and although the price might have gone down well below the $20 you have set, eToro will not realize that until the markets re-open and the lower price of this stock will be updated. Only then the stop-loss comand shall trigger even though you might have lost much more than the original level you set for this position.

Of course if the price drops down during the open times of the stock exchange when the price on eToro is being constantly updated according to it, the stop-loss will be triggered as soon as those $20 are lost as you have set up. When this situation happens outside market hours like in our example, eToro will close down your trade at the next best possible price level as soon as it sees the price went down way below your stop-loss level, for example to $70 or $60. That is much more than you originally planned to lose.

We can also visualize this situation on charts. Each candlestick bar on a price chart represents a one-day time frame of trading. If the bar is red, it means the opening price was the one at the top of the bar and it closed at the bottom of it, meaning the asset decreased in value. For the green bars the opposite is true, and the lower opening price went from the bottom of the bar to the top, meaning the price appreciated. Sometimes there is a gap between yesterday’s closing price and today’s opening price and that is what a price gap looks like on a price chart.

As you can see there are certain discontinuities or gaps between previous day’s closing prices and opening prices of the next day. Some of them are more noticeable, going against previous day’s trend and some of them are relatively minor.

Differences between gap types

There are actually 4 common price gaps that traders distinguish and trade on.

• Common gaps are, as the name says, pretty common and do not necessarily present a threat to the trader. These gaps are not very large and occur quite frequently, with the opening price being slightly different from the closing price of the previous day.

• Breakaway gaps happen in case the price moves over the resistance or below the support levels. Such a gap most times signals the beggining of a strong trend; for example the chart of Apple prices on the image below demonstrates a significant resistance level and breakaway gap that was formed around the beggining of August.

• Runaway/continuation gap: these gaps happen in the middle of a trend and indicate its continuation in the same direction. For example for an upward trend it may be caused by additional buyers that entered the market and bid up the price even higher. Both breakaway and runaway gaps may act a signal for a possibility to still benefit from an existing price trend.
• Exhaustion gaps: these usually indicate a change in the dynamic of a trend and may signal its reversal. It may be caused by a few ‘late’ traders who jump onto a trade in its last moments. After this latest increase in demand there are not so many traders left that keep on rising the price.

Managing Price Gaps

Because price gaps can impose serious dangers to your trading positions, there are several ways you can manage them on eToro.

Losses

Like in our example you can hopefully see that price gaps can cause losses on your trades. What if you used leverage and ended up losing more than your actual account balance? Will you have to return this money to the broker? Thankfully, eToro offers Negative Balance Protection which means you won’t actually own anything to the platform. In case your account equity becomes negative, eToro will set it to 0, review your trading account and absorb any losses that you have made.

When it comes to margin calls, let’s say you have several trades open at the same time and one of them is loosing because of for example a price gap. eToro will then perform a margin call and close down you other trades to compensate for the losses you are making.

How to manage this risk?

As you probably realized, price gaps may impose certain risks to your trading. Here are some possible ways in which you can mitigate them.

1. Stay on top of related news. For example, know the day of earnings report the company will issue, especially if you are holding an asset for a short time period hoping to make a profit on it. Earnings reports tend to increase price volatility quite a lot and you can minize the risks by not trading as much around the time of report announcement. Other major economic events like interest rates announcements or even presidential election results tend to cause additional market volatility you should account for.
2. Be aware of the leverage. Now a gap down may actually not harm your position as much, unless you are using leverage. Leverage allows you to amplify your size trade and profits, but losses too. Consequently, it enlarges the possibly negative effects of price gaps too.
3. Position sizes. The size of your trades is a very important factor in the entire process of risk management. Naturally, the larger the position in relation to your total account you take, the greater risk you are putting yourself under in case this trade ends up in a loss. If there is a risk of expected market volatility and hence there is a higher chance of a significant price gap you might consider reducing your usual position size to reduce the exposure it causes.
4. Hedging techniques. This is a very broad category but traders may use many different hedging techniques to protect their positions including trading options or shorting a similar security if they are long in the asset. A popular technique used for this is creating a ‘beta-neutral‘ portfolio which is completely protected from any market risks.

In fact some traders actually manage to trade and make a profit on price gaps. For example, some traders ‘gap and go‘, taking positions when a stock price undergoes a gap and setting stop-loss below the lower point of the gap bar. If the price gap happens above the resistance level there is a chance of making a profit when trading with high volumes. Fading the gaps is a strategy where investors trade in the direction opposite to the gap, setting a stop-loss level above the higher level of the gap’s bar. The same strategies can be performed on gaps down with opposite trades accordingly. There are many strategies traders can use to make a profit on these gaps which could be exploited in the short-term by taking substantial risks

For a more detailed guide on how to trade the Price Gaps, this article will help you to a more advanced level – https://torodemotrading.com/how-to-trade-gaps-on-etoro/

Hopefully now you are more familiar with what price gaps are, their types, what dangers they can cause to your trading positions and how to mitigate these risks. Remember that any trading entails capital loss risks and enjoy trading on eToro. Best of luck!

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