Pre-Market Trading Thoughts

This post was contributed by a guest author, and does not necessarily reflect the views of Richard or MovetheMarkets.com

After my experience with HOKU this morning, I thought a lot about pre-market trading. Spreads are wider and liquidity is thinner. You have to trade limit orders. Why trade pre-market? Because it can be great if you can get in ahead of the general public on something that runs wild at the open. Here’s some thoughts I had:

Before the open, some traders have access to trade things that are moving before the “general public” has a chance to bid for stock. Joe Six-Pack might give a buy market order overnight in AAPL after he reads some news, or sees an impressive run the prior day, or his newsletter says to buy, or whatever. His order waits until the open. If there’s just Joey-6, nothing much happens–order filled. However, if Joe and his other thousand buddies all decide the same thing, there will be a big backlog of buy orders, all to be filled at market. There may be some sellers on the other side that decide Steve Jobs is the devil. They probably won’t be exactly the same amount, share for share. What now?

If there is a specialist involved, they will have to decide on an opening price that best balances the supply and demand. But who wants that? There’s more transaction money to be made in wobbly prices. They will “try” to get it right, but most likely they will under- or over-price the open. Even if they do honestly try to balance the orders, the likelihood that they will get it exactly right to satiate all buyers and sellers is slim. So we expect some imbalance. Even if it somehow gets all matched up, the open brings a flood of new market orders from brokerages and other traders that didn’t have their orders in the market already. This will lead to price movement one way or the other at the open. Supply and demand dynamics change because the crowd has changed. And there’s no way good way to predict which way it will go–at least that I know of. Educate me if I’m ignorant!

If there’s no specialist involved, but just electronic market makers and other ECN participants, then my thought experiment is different. There’s no order backlog. Pre-market and post-open trading differs only in terms of operating hours of most brokerages and market participants. Fewer traders in pre-market means lower liquidity and wider spreads. There’s no specialist to guide prices, just the pre-market “smart money” traders (and me). These few participants wage their battle of supply and demand, with the fallout being price ticks. At the open, the same flood of market orders hits as above, and a new crowd of people joins the scene, altering the supply and demand dynamic, as well as the liquidity and spreads. They bring their own buying and selling pressure to the mix, which could be aligned with the pre-market traders, or it could not. Again, no edge that I know of.

Because you don’t know what is going to happen at the open in either case, specialist or not, I believe it is foolish to enter just prior to the market open as I did on HOKU. The pre-market supply/demand battle has already played out, and the new reinforcements for both sides are about to arrive on the scene. By taking your position before the open, you’re essentially walking out into the open in the middle of the battlefield with your bayonet, ready to defend your position, while the tank divisions are about to come over both hills. You’re probably gonna get blasted.

When would you want to trade pre-market? I can think of a few situations. One, where an overnight trade moved against you (or big time in your favor) and you want to get out at the price quoted, before the market opens and you could get massive slippage. The other is if there is an observed supply/demand imbalance early in the pre-market session, whether caused by overnight news, trader activity, or whatever. Look at my chart on my CBAK trade from 9/26/07:

At the start of pre-market trading, there was a gap, followed by an “OR” breakout. If you were watching then, you could have bought at about 8:45 ET and gotten a jump on the situation. There was a big cushion (+2R profit using the OR low as the stop) by the time the open came, and demand had not let up yet, so you could afford to wait and see what the open brought. The big buffer let you dig a foxhole out of the way of the approaching tank divisions, as it were, and it already looked like your side was going to win. Much better position to be in. Then you sell into the opening pop, after the momentum slows and bank coin. (+6R for this trade by my eyeball). Either way, there’s no edge to getting in just before the open. That’s just dumb to me.

Get in at the front of the pre-market session, or wait until after the open. Don’t be grease for the treads of other trader’s tanks. Comment if you agree, disagree, have supporting or contradicting ideas!

This post was contributed by a guest author, and does not necessarily reflect the views of Richard or MovetheMarkets.com