Night Trading: A New Look at a Market of Opportunity (Part 2)

  • April 3, 2008
  • Brooks McFeely

Night Trading: A New Look at a Market of Opportunity (Part 2)

A Predictive Tool: Analyst Rating Changes

Among the many regular overnight occurrences, analyst rating changes tend to be among the most followed, regular and impactful as it relates to a stock’s future price activity. Almost always issued during the pre-open session, the rating change effect on the underlying security tends to be both valid and significant. However, many investors tend to overlook or simply don’t know about the trading activity in the pre-open following a rating change.

Many investors have fallen for the common mistake of assuming an upgrade will result in a price gap up and likewise a downgrade a gap down at the open. The first and most immediate value presented by having knowledge of pre-market news and trading activity is that there is rarely a price gap in either direction. In other words, there tends to be orderly pre-market trading leading up to the opening bell which is nearly always misrepresented in the financial press as a gap in price.

Let’s take a look at an upgrade of Goodyear Tire issued in the pre-market by Deutsche Securities from buy from hold. Following the upgrade, roughly 600,000 shares traded, representing over 10% of GT’s average total daily trading volume. In summary, the stock closed the previous regular session (prior to the upgrade) at $21. Following the upgrade, most of the 600,000 shares were traded in the pre-market session between $21.30 and $21.50, well below what would be that day’s regular session closing price of $22.80. (see figure 1 below). Buyers in the pre-market had plenty of time to pick up shares of this tire manufacturer at very attractive prices before the open.

Figure 1 – Goodyear Tire

This example is somewhat oversimplified to the extent that significant emphasis must be put on the stock’s history of reacting to analyst rating changes in the pre-market. Not all stocks will react the same way as GT to a similar upgrade, in fact there may be little or no movement as a result. In the case of analyst rating changes, history tends to be a very good guide. For instance, Goodyear Tire tends to be consistently under-priced following a rating change in the pre-market relative to the following regular session.

On the flip side, high fling Google has a very different history in reacting to analyst rating changes before the open. Over 80 percent of the time, GOOG tends to overreact in the pre-open session following rating changes relative to the following regular session. In this recent instance, an upgrade by UBS sent shares up to over 2 points on 120,000 shares ($58 million dollar volume) from the previous 4 pm close, only to see those gains and more dwindle during the first few hours of the following regular session. (see figure 2 below). Clearly a shorting opportunity.

Figure 2 (Google)

In addition to stock and event specific history, price and volume must also be considered in determining valid pricing following any event related trading activity in the off-hours. Not unlike the well known technical pricing rule in regular session trading, light trading volume and low liquidity tends to increase the degree of mispricing. In the Google example, only about 3 percent of GOOG’s total daily volume was traded before the open. Clearly enough liquidity for most participants to enter or exit a position, but not enough to validate the price move.

A Mainstream Market

Investors shouldn’t wait any longer to get connected with extended-hours trading news and information. With off-hours trading having been adopted by mainstream brokers and traders – and even the smaller ones – liquidity and opportunity are present and growing after the close and before the bell. While extended-hours trading promises greater opportunities and convenience for investors, it also carries risk. However, these risks are not unlike those of trading in the equities markets at anytime of day, regular session included. With knowledge of market structure, access to real-time information and a well developed strategy, you’ll be able to mitigate much of the risk and profit from it.

Brooks McFeely is widely regarded as the leading expert on extended-hours trading. He is a Managing Partner for Brochet Capital Partners, LP and the founder of Midnight Trader, Inc. (www.midnighttrader.com), the leading provider of pre-market and after-hours trading analysis and news to retail and institutional investors.