Wednesday, October 10, 2018

Another example of a nasty price gap

If you subscribe to the Mark Douglas theory that in the markets anything can happen, at any time, then you will know and accept the potential effect that sudden or unexpected announcements can have on price of a stock or instrument.

Seemingly you can be comfortably sitting in profit on a trade, even with your trailing stop above your entry price, only for a price gap to occur against you, resulting from the reaction to such an announcement.

It is for this reason why I never take into account open profits for position sizing purposes. A profit or loss on a position is not known until the trade is closed. Open profits can disappear - seemingly overnight with little or no warning, and your trailing stop may be rendered worthless.

Of course, certain stocks in certain sectors may be more prone to these types of price shocks - a small cap oil exploration stock, for example, may suffer from an adverse price gap if after drilling they come up dry. 

Another example could be where a company is involved in  the biotechnology or pharmaceutical industry, where new products are subject to external scrutiny and approval from agencies like the FDA.

One such example is the US stock Trevena Inc., which I came across on social media yesterday:

In this particular example, we can clearly see a breakout from a period of consolidation, and on Monday's close you would have been sitting on a profit around +7R.

However, before the markets re-opened yesterday, some comments from the FDA related to a new product sent price tumbling - the open profits vanished and you would have been confronted with a near -5R loss on the open.

This is just another example of why being conservative in your risk per trade is so important in surviving in the markets.

As always, where there is potential reward there is always risk. And in certain cases you may take the view that the perceived risk may be higher than others, but it is worth remembering that risk is always present in any stock, in any sector.

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