03/06/2019 |
Extended-Hours Trading: Benefits, Drawbacks, and Strategies
Imagine that a stock that you’re following reports blow out earnings after the closing bell. Wouldn’t it be nice to purchase the stock before the market opens the next day? Extended-hours trading enables you to make these kinds of trades, but there are important trade-offs to consider.
Regular stock market hours run from 9:30 a.m. to 4:00 p.m. Eastern Time every weekday (except holidays). If you want to react to news outside of these hours, you can place trades during extended-hours sessions, including pre-market starting as early as 4:00 a.m. and after-hours as late as 8:00 p.m.
In this article, we will look at how extended-hours trading works, important differences, benefits and drawbacks, and some strategies for active traders to consider.
How Do Extended Hours Work?
Most trading takes place on major stock exchanges like the NYSE or NASDAQ. When these exchanges close, extended-hours trading moves to Electronic Communication Networks, or ECNs, which match up individual buy and sell orders. The result is much more a “market of stocks” than a “stock market”.
For example, if you place a limit order to buy 100 shares of a stock at $25.00 per share, the ECN will look to find a limit order to sell at least 100 shares at $25.00 per share. The trade won’t be filled unless there is a counter-trade, but commissions and settlement times are generally the same.
Most brokers require their clients to agree to ECN user agreements before trading during extended hours. In addition, some brokers require a discussion with a representative to ensure that their clients understand the risks associated with trading during extended-hours sessions.
The trading process is very similar to normal market hours with a few exceptions. You can only use buy, sell and short limit orders to buy NYSE, NASDAQ and AMEX-listed stocks during extended-hours sessions. These trades don’t carry over to the regular session and are limited to 25,000 shares per order.
Why Trade During Extended Hours?
There are many reasons to place trades outside of normal market hours. Depending on your trading strategy, extended-hours trading can be an integral part of your day or a rare exception to the rule. The key is understanding the benefits and drawbacks of extended-hours trading before getting started.
The three biggest advantages of extended-hours trading are:
- Convenience: You can place trades during extended hours if you’re unable to trade during normal market hours. For example, you may be at work and miss the opportunity to trade during regular hours, but you can still place a trade during the after-hours session.
- News & Events: You can use extended hours to respond to earnings, acquisitions, or indicators that are released outside of regular market hours. For example, you may want to react to the non-farm payrolls report before the market opens or place a trade following an earnings report after the bell.
- Technical Analysis: You can react to technical trading signals before the market opens the following day. If a stock breaks out from trend line resistance, you create a limit order to buy before the market opens the following day.
Here’s an example of Abercrombie & Fitch Co. (NYSE: ANF), which rose more than 20 percent on March 5, 2019, following better-than-expected earnings:
The initial move higher was made at 5:30 a.m. immediately following the earnings announcement and the price continued to move higher until the market opened. Traders that bought in during pre-market hours could have secured a much better price than those that waited for the regular market hours to begin.
What Are the Drawbacks?
There are many reasons to consider extended-hours trading, but there are many important drawbacks to consider. In many cases, these drawbacks outweigh the advantages of regularly trading during extended-hours sessions. The exceptions are institutional investors or experts with well-defined strategies.
The three biggest drawbacks of extended-hours trading are:
- Prices: Stock quotes may not represent the current prices available across all extended-hours trading venues, which means that you may not be getting the best possible price. Extended-hours prices also do not transfer over to the regular session in any way—they are completely separate.
- Liquidity: Extended-hours trading has less liquidity than regular hours, which translates to wider spreads and greater volatility. Your orders may experience delays, partial fills or no fills at all, while pricing can be inferior in securities that have low trading volume.
- Uncertain Fills: You only have access to buy, sell or short limit orders during extended hours, which means that there’s a good chance that your order will experience a partial fill or no fill at all. There’s no fill-or-kill option to create a reliable fill every time.
Extended-Hours Trading Strategies
There are a couple of trading strategies that can be profitable during extended-hours sessions, but it’s important to realize that they may involve a greater level of risk than other trading strategies executed during regular market hours.
Two popular extended-hours strategies are:
- Arbitrage: Acquisitions that are announced outside of regular market hours could create a short-lived arbitrage opportunity. Experienced traders can try to buy the acquisition target and short the acquirer to capitalize on the difference between the market and purchase prices.
- Playing the Gap: Many active traders use gap trading systems. Since gaps regularly occur during extended hours, there may be an opportunity to trade these gaps and profit from them. Another popular strategy is to fade any gaps that occur at the open of a regular session.
The Bottom Line
Extended-hours trading provides you with an opportunity to buy and sell stocks outside of regular market hours, but there are significant liquidity-related risks to consider. Most traders should avoid trading during these timeframes unless they have a well-defined trading strategy or a clear rationale in place.
