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Late Trading: A Practical Guide
By Stephen Hill
The Regulatory Advantage
The immense political and financial clout that the established securities exchanges and markets have in this country for preserving the status quo is nearly unparalleled. Indeed, though the Congress directed the SEC to create a national market system in 1975, it wasn't until late 1999 that retail traders were allowed equal access to pre-market and after-hours trading. For years, institutional investors and market professionals negotiated transactions among themselves in a very limited and exclusive version of the extended-hours market. Today's version is participant driven, more consolidated, reasonably liquid, transparent and inherently safer than regular session trading.
Despite mixed feelings expressed by exchange officials, specialists and professional market participants, in mid-1999 growing numbers of broker-dealers began providing their retail customers with the ability to have their orders directed to ECNs after the major markets closed. The trading rules, while different than those that govern regular session activity, provide both enhanced investor protections as well as some significant advantages.
From a protection standpoint, the differing participation rules relate mainly to order criteria. While both 'Market' and 'Limit' orders exist as common order types in regular session trading, 'Market' orders are not authorized in extended trading. In other words, it's a limit order only environment overnight. While it may appear that the elimination of market orders during the extended-hours would be a great disadvantage, it's quite the opposite. As seasoned traders know, market orders are typically used by unsophisticated retail investors, unnecessarily giving up significant price concessions to get small orders filled.
Despite the SEC's best efforts to over regulate individual investor participation in the capital markets, transacting after the close and before the open of regular trading offers significant advantages with increased protection that should not be overlooked.
The Short Story After Hours
Fear is stronger than greed. When companies report weaker than expected quarterly earnings, a primary driver of extended trading, traders often waste no time in voting their collective displeasure. Typically, within seconds of an earnings release in the after-hours or pre-market, significant volume and price activity follow with dramatic results. Large and small cap stocks alike often move significantly higher or lower on tremendous after hours volume, typically equal to or greater than fifty percent of the issues average volume for an entire day.
Where is the opportunity? How can I possibly react within seconds of an earnings release or other news? Forget everything you've learned about reacting to news in regular session trading. Event driven trading in the regular session is far more difficult and restrictive (on the short side) than in the after-hours. Regular session event trading requires a finger on the trigger at all times and the ability to compete with automated trading programs and algorithms. For even the most seasoned retail traders it's a losing game.
Despite the surge of trading and almost instantaneous institutionally driven repricing following significant news after the close, there remain opportunities
for the retail trader which doesn't require rapid fire trading. Let's take a close look at a recent earnings event driven trading on Whole Foods Market, Inc. (WFMI) in the after-hours and following day.
Whole Foods Market released disappointing earnings after the close on Wednesday, May 9, 2007. According to MidnightTrader.com, WFMI dropped immediately following the news of an earnings and sales shortfall, plummeting from the regular 4 PM closing price of $45.80 to just under $43 or better than 6 after hours. It slid further the next day, losing a whopping 11.7 within 24 hours. No need to trade within seconds or even minutes following the release, giving night traders with access to real-time after hours trading information plenty of time to digest the news and accumulate a short position.
Clearly, the shorting opportunity was easily available at anytime during the after-hours and early pre-market sessions. By the time the opening bell rang, the downside was already priced in. Too late for the rest of Wall Street to participate.
Liquidity you ask? Not a problem. WFMI recorded after hours volume that night of over 1.7 million shares, better than 50 from the 4 PM price of $56.15 to $54.15 by the 8 PM close of after hours trading.
Opportunity Identification & Risk Management
While there are certainly tremendous short sale opportunities after hours, there are also risks. Not unlike any investment vehicle or regular session participation, short selling has risks equal to its rewards. Successful investing requires a stringent and methodical approach and dedication to risk management. In other words, opportunity selection and capital allocation coupled with a well defined exit strategy is essential for long term profitability.
Regarding opportunity selection, history and liquidity are the most significant characteristics of position selection. Access to comparable issue specific historical event reaction information is necessary in order to effectively predict future price movement. Without volume and associated liquidity conditions after hours price movements cannot easily be validated or sustained. In addition, since the extended-hours are totally participant driven, picking up a position of meaningful size would not be possible. Avoid stocks with limited or low volume/liquidity characteristics regardless of the news or its reaction history.
Shorting after hours is another technique you can add to your trading toolbox. That is, if it fits with your risk tolerance and investing style. Short selling in the extended-hours provides a sizable opportunity with manageable risk. As with trading any instrument in any environment, understand the rules and get the market data tools necessary to support smart decision making. Enjoy the benefits of late trading but don't fall asleep at the wheel. By: Stephen Hill Article Directory: http://www.articledashboard.com Brooks Mcfeely is one of the most knowledgeable sources on extended-hours trading. His commentary has appeared in the Wall Street Journal, Financial Times, and CNBC television.www.midnighttrader.com/visit.php?source=1&tag=AIQtag
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