What it means
Most day traders close all their trades before the end of the session to avoid surprises. Anyone who keeps a position through the night accepts the risk that news, results announcements or events overseas will move the price before they can react.
When the market opens, the price can jump to a very different level from the previous close. That jump is called a gap, and it is the main danger.
A stop-loss order (an instruction to sell if the price falls to a set level) may not protect the holder, because the market can open far below the stop price. The loss is then bigger than planned.
Overnight positions can also carry financing costs. A leveraged position, for example in foreign exchange or on margin, may incur an overnight interest charge or credit depending on the difference in interest rates.
For positions held for many nights, these charges can matter as much as the price movement. Banks and brokers set limits on overnight positions separately from daytime limits, and they often require more margin to hold a trade overnight.
Risk teams review the total at the close of each day and report it to management. Corporate treasurers face a similar issue when a foreign currency position stays open between trading sessions.
Some investors deliberately hold positions overnight because they expect favourable news or want to capture longer-term moves. Doing so is a choice to accept gap risk in return for a possible reward.
Time zones add a twist. A position that is overnight for a trader in New York is in the middle of a working day for a counterparty in Tokyo, which is why large banks hand their trading books from one regional desk to the next.
In practice
Real-world examples.
Example
A currency dealer ends the Asian session holding a $5,000,000 long position in a currency pair. Overnight, a central bank statement moves the exchange rate against the position. The dealer faces a loss before the European session starts.
Example
A retail investor buys shares on the afternoon before a company reports earnings and holds them overnight. The results beat expectations and the shares open 6% higher. The investor gains $1,800 on a $30,000 holding.
Example
A commodity trading firm keeps a hedged oil position open overnight. The risk team checks that the exposure sits within the overnight limit of $10 million. The check takes place daily before the close.
Formula
Calculation
Overnight gap profit or loss = number of units x (next day opening price - previous closing price)
Total overnight cost = gap profit or loss - financing charge
A trader holds 2,000 shares closing at $40.00. The company then announces weak results after the close, and the shares open at $36.50. Gap loss = 2,000 x (36.50 - 40.00) = 2,000 x (-3.50) = -$7,000. If the trader had a stop-loss at $38.00, the order would have been executed near $36.50, not $38.00, so the stop only limited the loss to the opening price.
Reading the result: the gap cost the trader 8.75% of the position value of $80,000 (7,000 / 80,000), far more than the 5% loss that a stop at $38.00 was supposed to allow. If a financing charge of $12 also applied, the total cost was $7,012.
Position size scales the risk directly. If the same trader had held 4,000 shares, the gap loss would have doubled to 4,000 x 3.50 = $14,000, so halving the size of an overnight position halves the potential gap loss.Case study
Seen in the real world.
Greystone Capital is an illustrative, fictional proprietary trading firm that allowed traders to hold positions overnight with a limit of $3,000,000 per desk. One trader kept $2,800,000 of a single technology stock because he expected strong results.
The company issued a profit warning after the close, and the shares opened 11% lower. The loss on the position was 2,800,000 x 0.11 = $308,000, and the firm's stop-loss orders gave no protection against the gap.
The risk committee then lowered the overnight limit for single stocks to $1,000,000 around earnings dates. This illustrative change cut the maximum gap loss on a single position to about a third of the earlier figure.
Watch out
Common mistakes.
- Believing that a stop-loss order guarantees an exit price, when a gap can take the market straight past the stop.
- Ignoring financing costs on leveraged positions held for many nights.
- Using the same position size overnight as during the day, when the risk is higher because the market cannot be traded freely.
Questions
People also ask.
Why do brokers ask for more margin overnight?
Because gaps can create large losses before positions can be reduced, so the broker wants extra protection.
Is an overnight position the same as a swing trade?
They overlap, as a swing trade is held for several days and therefore includes overnight positions, but an overnight position can be a single night.
How do risk teams manage them?
They set limits, review totals at the close of each day and often reduce exposure ahead of known events such as results.
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