Gap risk: what it means and how to avoid it

What is gap risk?

Gap risk can occur in every market, spot forex included. It is defined as the potential for a market to move sharply in price with no trading in between - usually due to such market being closed. For forex, this risk increases over the weekend since markets close Friday at 5pm ET and do not open until 5pm ET Sunday.

The most recent example of gap risk can be seen in US dollar against the Israeli shekel. War against Hamas broke out over the weekend and when markets reopened, the opening price of USD/ILS was much higher than Friday’s closing price.

How does gap risk differ by product type?

While all markets are subjected to gap risk, different products have varying degrees of risk because of their market hours. Stocks tend to be the most exposed, while futures, forex and crypto have less exposure to gap risk.

• Stocks – open 9:30am to 4:00pm ET (excluding after hours) – are subject to nightly risk and weekend risk
• Futures – open 6:00pm to 5:00pm ET (hours may vary by product) – generally have only an hour of downtime daily, trading nearly six days a week
• Forex - open 5:00pm to 5:00pm ET – has no downtime during the week, but close from Friday to Sunday
• Crypto – open 24/7 – has minimal exposure for gap risk due to downtime

How does liquidity affect gap risk?

Even when markets are open, trade volume and illiquidity can affect gap risk as well. For forex markets, the time from New York’s close (4:00pm ET) to when Asian markets begin to open (around 8:30pm ET) presents a window of lower trade activity. Trading activity decreases during this time because of lower volatility - no major stock markets are open and there is generally no economic news announcements or data releases to stir markets.

Spreads are subject to widen during this time and jumps in price are possible, especially in less liquid pairs.

Weekend downtime

Weekends pose the most straightforward gap risk in forex markets, as it is the only time each week that trading is suspended. While economic news announcements should not typically arrive during this time, geopolitical events that could affect economic volatility could still develop or arise unexpectedly.

The most recent example of a weekend gap was seen earlier this month when Israel declared war on Hamas early Sunday morning. The outbreak of war would weaken the Israeli shekel against the US dollar, but any movement could not be traded until markets opened Sunday night. As shown below, by the time markets opened USD/ILS had jumped over 1000 pips higher – forcing traders with open positions in the pair to react to the new opening price level without being able to manage their position during its appreciation.

USD/ILS price history

Risk management

There are several ways to mitigate gap risk in a portfolio depending on level of engagement and risk tolerance. The most effective way to do so is to avoid holding positions overnight. While requiring active management, closing positions during the trading day would limit exposure during downtimes in the evenings and during market close over the weekend.

A less active strategy to hedge against gap risk is diversification. By holding several currency pairs that move independently of one another, a gap in any one pair would minimally affect the portfolio overall. Checking historical correlations between forex pairs is an important tool for risk assessment.

Similarly, traders may simply choose to lower exposure and position sizes during times of high potential risk. This could mean winding down positions over the weekend or moving away from less liquid pairs during times of uncertainty.

Learn more about risk mitigation using stop-loss orders

Trading using gap analysis

Traders may also use gaps to their advantage and open positions following a gap up or down. If the gap is believed to be the start of a larger trend, traders could take a position in the same direction of the gap - hoping to capitalize on the gap’s momentum.

Conversely, if they believe the gap is an overreaction and the pair will revert, traders could choose to fade the gap and take a position in the opposite direction of the gap. While this could incur losses in the short-term, traders would expect the gap to fill quickly thereafter.

Learn more about trading using gap analysis in forex

How to trade 24/5

1. Open an account to get started, or practice on a demo account
2. Choose your forex trading platform
3. Open, monitor, and close positions on forex pairs

Trading forex requires an account with a forex provider like IG. USD/JPY can be found in IG's platform under the 'Major' pairs tab. Many traders also watch major forex pairs like GBP/USD and USD/JPY for potential opportunities based on economic events such as inflation releases or interest rate decisions. Economic events can produce more volatility for forex pairs, which can mean greater potential profits and losses as risks can increase at these times.

You can help develop your forex trading strategies using resources like IG’s Trading Academy. Once your strategy is developed, you can follow the above steps to opening an account and getting started trading forex.

Your profit or loss is calculated according to your full position size. Leverage will magnify both your profits and losses. Risk management is important as losses can exceed your deposit. Ensure you understand the risks and benefits associated with trading leveraged products before you start trading with them. Trade using money you’re comfortable losing.