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Gap risk refers to the risk that the price of a particular investment security can change significantly without any market trading taking place. If an investor is holding such a security, the drop in value can be damaging to a portfolio. It is necessary to be concerned about gap risk, which commonly occurs with company stock, if some after-hours news announcement causes a change in how investors view the stock in question. To manage this risk, investors should consider either hedging against a price drop or perhaps even selling the stock to avoid the potential drop.
When stock prices change during a trading day, investors can be aware of the upward or downward movements of the stocks that they hold. In this way, if the price of a particular stock starts to plummet quickly, they can usually get rid of it before any major damage is done. There are certain occasions, however, when a stock's price can change without a single trade affecting it. These overnight price variations can be harmful, so investors must be conscious of the concept of gap risk and how to manage it.
This phenomenon is known as gap risk because of the gap that is created when the price of a stock drops from its closing price one night to its opening price the next morning. The difference between the two prices is the gap. It can be a benefit to investors if the price of shares that they hold jumps overnight, increasing the value of those shares. By contrast, a sudden drop in price is a serious problem for investors holding on to a stock.
There are various reasons why such gaps occur and necessitate investors worrying about potential gap risk. It is common for the earnings reports of companies that offer stock to be released after trading hours. If the earnings reports are not emblematic of the price at which the stock is trading, a gap will likely occur. In addition, an unforeseen, negative event that befalls a company in non-trading hours can lead to a overnight stock plunge.
With all of possible causes of a gap looming, investors must decide how they wish to handle gap risk. The simplest way to avoid it is to sell the stock containing gap potential. For example, if an investor gets wind that earnings reports for the company issuing him stock are in the offing one evening, he can simply sell the stock before trading closes to avoid the fallout of a disappointing report. Hedging, which can be achieved by buying options to sell a stock in danger of gapping, can also mitigate the damage of a price drop.