Sizing swing positions with gaps in mind

What you will learn

• Why stop-based sizing alone underestimates the risk of a swing position
• How to set a stress gap for each share and calculate the gap loss
• How to size with three limits: stop risk, gap-stress loss and position value
• How to express gap exposure in R and compare setups

Explanation

Basic position sizing (shares = euro risk ÷ stop distance) is covered in the Risk Management course. It assumes that you exit at the stop. Lessons 1 and 6 showed that a swing position can open far below its stop. A swing trader therefore needs a second question for every position: "If this share gaps by a large amount tomorrow, how much do I lose, and can I accept that?"

The stress gap

The stress gap (g) is a percentage move you assume could happen overnight. It is a planning number, not a forecast. Ways to choose it:

• Look at the share's daily chart for the last two to three years and find the largest opening gap; use at least that.
• For a position held through earnings, use about twice the implied move from lesson 6.
• Without data, use a fixed default by type, for example 10% for large, stable shares and 20% or more for small or volatile shares.

Historical gaps show what has happened, not the limit of what can happen. Choose the stress gap conservatively.

Three sizing limits

Calculate three share counts and take the smallest:

1. Stop limit: N1 = risk budget ÷ (entry − stop)
2. Gap limit: N2 = maximum stress loss ÷ (entry × g)
3. Value limit: N3 = maximum position value ÷ entry

Always round down. Typical starting values, to be written into your own plan: risk budget 0.5% to 1% of the account, maximum stress loss about 1.5% to 2% of the account per position, and maximum position value about 20% to 30% of the account.

Gap exposure in R

A useful comparison number is:

Gap exposure (R) = (entry × g) ÷ (entry − stop)

It shows how many R you lose in the stress gap if you size only by the stop. A setup with a 2% stop and a 15% stress gap has a gap exposure of 7.5R: one bad night can wipe out the profit of several good trades. Tight stops look efficient, but they create large positions and therefore large gap exposure.

Leveraged products

With CFDs, the margin you post is only a fraction of the position value (leverage and margin are covered in the Risk Management and Derivatives courses). The gap loss is calculated on the full position value, not on the margin, so leverage makes it easy to build a position whose gap loss exceeds what you planned. The same three limits apply, using full position value.

Worked example

Hypothetical example: account €30,000. Risk budget 0.5% = €150. Maximum stress loss 1.5% = €450. Maximum position value 25% = €7,500. Two setups at an entry of €40.00:

In both setups the gap limit is the binding constraint. In setup B, sizing by the stop alone would have meant a stress loss of €1,122, or 3.7% of the account, from a trade "risking" 0.5%. The cost of the gap limit is a smaller planned profit: at final size B risks only €60, so a 2R winner earns €120 instead of €300. Excluded: costs, slippage and taxes.

Common mistake

Practice activity

Hypothetical data: account €20,000. Risk budget €150 (0.75%), maximum stress loss €400 (2%), maximum position value €6,000 (30%). Entry €25.00, stop €24.25, stress gap 12%.

1. Calculate N1, N2 and N3 and the final share count.
2. Calculate the stop risk and the position value at the final size.
3. Calculate the gap loss if you had sized by N1 only, and the gap exposure in R.

Key takeaways

• Size swing positions by the smallest of three limits: stop risk, gap-stress loss and position value.
• Choose a conservative stress gap from past gaps, implied moves or a default by share type.
• Gap exposure in R shows how much one bad night can cost; tight stops increase it.
• With leverage, calculate gap loss on the full position value, not on the margin.

Next step

In the next lesson you learn exit rules for swing trades: time stops, trailing stops and partial exits.