Swing trading is all about holding positions for days or sometimes even weeks to capture larger market moves. But it also has the challenge of overnight risk. To overcome these risks prop firms provide great opportunities to traders. Prop firms provide traders with a large amount of capital to save larger positions. To manage this large amount traders must have a proper risk management that helps them to protect the firm’s capital. Traders can execute their strategies when they have a large amount. But handling overnight risk is not an easy task. Traders must have strategies to manage this overnight risk. If you dont know then let’s discuss in detail the strategies that traders have to use to overcome overnight risk.Â
Understanding Overnight Risk
Before going to the main topic of how prop firms handle overnight risk let’s talk about what it actually is. Holding a trade overnight means you can take advantage of price movements that take place after the market has closed. These price movements can be in the favor of traders and can be risky for them. During the night different earning reports, geopolitical developments, and unexpected news could be issues about the price changes. Swing trading is different from day traders who can exit before the closing bell. Swing traders must be prepared for potential price gaps when the market reopens. For prop firms, this is a big deal. They must have strict risk management processes to reduce the risk because one unexpected action can greatly impact the money of prop firms.
Risk Management Techniques Used by Prop Firms
Position Sizing and Leverage Control
Prop firms don’t just let traders go and save oversized positions. They apply different limits on the size of trades relative to account equity. When they apply leverage limitations and enforce proper position sizing that traders must follow then it helps them to save from losses even if a trade moves against a trader overnight. Most firms require traders to stick to risk-reward ratios that align with their guidelines. For example, a firm mandates that no single position can risk more than 1% of the trader’s allocated capital. This ensures that even multiple losing trades won’t destroy the account.
Daily and Maximum Drawdown Limits
To prevent traders from destroying their accounts due to overnight risk, prop firms set strict drawdown limits. There are two types:
- Daily drawdown – A trader can’t lose more than a set percentage of their account in a single day.
- Maximum drawdown – A trader is given a hard stop on losses over time. If they hit this limit, their trading privileges may be revoked or their account reset.
With the help of these limitations, firms prevent traders from taking on excessive risk in hopes of overnight gaps working in their favor.
Hedging and Portfolio Diversification
Some prop firms hedge their positions to offset potential overnight risks. This can involve buying options to protect against downside moves or diversifying across different asset classes to reduce exposure to any single market event.
For example, if a firm has traders with heavy long positions in tech stocks then they can take a hedge position in an inverse ETF or an options strategy to limit potential losses. Some firms even encourage traders to maintain a diversified portfolio instead of putting all their money in a single trade.Â
Reduced Leverage for Overnight Holdings
Many prop firms help traders use higher leverage for intraday trading but reduce that leverage significantly for overnight trades. A trader who has access to 10:1 leverage during the day might be limited to 3:1 or less if they want to hold positions overnight.
This forces traders to be more selective with their overnight trades and discourages reckless risk-taking.
Overnight Holding Fees or Capital Requirements
To discourage unnecessary overnight exposure, some firms charge an overnight holding fee. This fee compensates for the additional risk and capital exposure the firm takes on. Some other firms require traders to maintain a certain cash balance or adjust their risk limits if they plan to hold trades overnight. This helps traders don’t overextend themselves without considering the risks.
Use of Stop-Loss Orders
Prop firms often enforce stop-loss rules that require traders to place stops on all overnight positions. This ensures that if the market gaps against them then they at least have a predetermined exit strategy to minimize losses. Stop-loss orders can’t protect against extreme gaps but they do provide a safety net against gradual unfavorable moves.
Pre-Approved Overnight Trades
Some firms go a step further and require traders to get approval for overnight positions. This is especially common in firms that specialize in funded trader programs. Traders might have to submit a plan explaining their overnight trade’s rationale, stop-loss placement, and risk-reward analysis. The firm’s risk management team then decides whether to allow it.