Broker Check

After Hours Trading:  What’s going on there?

| May 24, 2018
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Conventional wisdom may lead you to believe that the trading platform that offers the most bells and whistles will result in the best performance.  In the words of Dr. Ian Malcolm, “…your scientists were so preoccupied with whether or not they could that they didn’t stop to think if they should.”  The results of that experiment are well-documented1...  So the first question we should be asking is SHOULD we be participating in after-hours trading?

First off, how is after-hours trading accomplished?  What is happening here?

The exchanges are closed, but technology allows investors to trade directly with each other via electronic communication networks, (ECNs).  An ECN connects investors directly with one another outside the support of an exchange.  ECNs include embedded costs in exchange for their services.

Ok, so what is the downside?

First off, stocks have much wider spreads after hours.  Every time you enter a trade, there is a bid-ask spread that determines the execution price.  After hours, since the volume is so much lower, the spreads are much wider.  This leads to less favorable execution and lower liquidity.  The main function of an exchange is to provide liquidity, tight spreads, and price transparency.  Those benefits are limited after hours so you are somewhat in the dark.  If you do participate in after-hours trading it is wise to use limit orders.

Here is another major drawback – you don’t know who you are trading with after-hours but you are likely to be swimming with sharks.  Think about this for a second.  Trading is a zero-sum game.  For every buyer there is a seller on the other end.  A large amount of after-hours trading is done by large institutional traders.  They have more resources than you.  These firms have analysts whose entire full-time jobs are to know everything there is to know about one or two stocks.  They use volume and algorithmic trading to optimize their execution.  ECN’s mask traders, so you have no idea whether you are trading with your next door neighbor or a hedge fund.

For example, if a stock has a poor earnings announcement after the bell, the seemingly logical trade (AKA the sucker bet) might be to overcompensate and rush to sell after hours, driving the price artificially low.  Remember for every seller there is a buyer.  Who is buying those shares on the other end?  It could be a trader who isn’t afraid to buy into the bad news if he or she sees a stock trading at a bargain (AKA the smart money).  So when individual traders are given access to institutional trading technology, it is like throwing a bucket of chum into the shark tank.  Yes, the chum is you.

But the biggest drawback might actually be that volatility and risk are amplified after hours.  Driving a racecar without a restrictor plate might allow the car to go faster – but it is also a lot more dangerous.  Without the liquidity and transparency provided by the exchanges, stock prices can fluctuate wildly.

For instance, let’s look back to the night of the 2016 election.  The S&P 500 index futures were down almost 5% in the middle of the night as investors panicked at the surprise result.  By the time the market opened it was… UP.  And then it ran and ran and ran some more.  Reactionary investors got smoked while the smart money swooped in and mopped up.

The consequences of poor decisions that investors make based on fear, emotions and behavioral biases are amplified after hours.  Granted, the election was a dramatic example.  Though trading after hours is the type of strategy you might get right 7 out of 10 times, the 3 misses could really sting.  If you have a regular savings plan in place and you are on track for retirement, you shouldn’t NEED to be a day trader and attempt to cut corners.  So why expose yourself to the risk?

I’m a pretty good softball player.  Maybe that statement needs a little more context so I will clarify.  I am an above-average player in the Worthington Tuesday nights mens’ recreational softball league.  The after-hours trading equivalent would be if I took my softball bat to try out for the major leagues.  I would be competing against players I don’t know who are far better-prepared who play baseball for a living and with much better equipment.  Those are not conditions in which I would be willing to bet my retirement money.

 

1This is a Jurassic Park reference.  Dr. Malcolm was the dude played by Jeff Goldblum.

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