There’s a weird theory that stock markets don’t actually make money when they’re open. It is only when they are closed that prices move enough for us investors to cash in. The obvious reaction, if true, is that we are trading the S&P 500 (US500) overnight. Or maybe mini futures, or something like an S&P 500 ETF. The specific instrument used will depend on risk appetite, trading costs, position size, etc.
Of course, it is necessary to determine if the claim is true before anyone starts trying to trade it and there is the small difficulty. Because we have observed a trend, but it has not been observed for a very long time and we do not know if it will persist. This is also called “temporal arbitrage”. We have already talked about arbitration, it depends on the idea that things are fungible. This idea of timing arbitrage is different, in that we are not buying and selling at the same time to guarantee a profit. Instead, we have a pattern that seems to repeat itself over time, so we can follow that pattern over time. Or, the other word for it is speculation.
So the claim is that the S&P 500 is going up over time, of course. Part of that is because the economy has grown over time, which obviously goes hand in hand with the value of large companies. Also, stock indices are not revalued with inflation – so falling in the value of money over time always causes the ADI, S&P, FTSE100 to rise over long periods of time. It is also true that we have just had decades of rising stock markets, the mirror image of the long decade of falling real interest rates. Bonds are worth more when interest rates are high, stocks when they are low, that’s how it works.
The observation is that if you extract the change in the S&P 500 within the day – when the markets are fully open – and overnight – which includes post-trade and pre-trade – then the entire upside of the index occurs the night. A recent estimate is that the intraday rise is around zero, the overnight rise around 1000% since around 1990. It’s on the SPDR S&P 500 ETF.
Well, it is possible to just swap models like that. This is what high frequency trading and the algorithm is all about. The models exist, nobody – not even the AI - knows why, they trade them until they stop making money, then they stop trading the model. We might want to put a little more effort into understanding why a trend is happening because after all, we are not a hedge fund playing with other people’s money.
The problem is that no one knows why this model exists. A very serious idea – based on Vanguard S&P 500 futures – is simply that Americans don’t know what prices should be. So they need Europeans, when they wake up (that 2am to 4am period in the US) to tell them what they should be. As alluring as this idea is, which we grown people have to tell them, there is a certain lack of evidence. Observation, yes, but not proof. The Federal Reserve is sure that it is the additions of 24-hour futures to the system that are the reason, but again exactly and precisely why, well, shrug your shoulders? Incidentally, the big structural change is indeed that futures contracts now trade 24/7, which means that the stock markets themselves, well, they’re not the only price action in town.
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Another – and very annoying – answer is that stock markets are closed for more of this new 24 hour trading period than they are open, so of course more of the price action occurs when stock markets are closed. Oof, now how interesting is it to argue about the number of hours in the day?
A really interesting – really, really fun – argument is that tall hedges lead a massive pump and dump. In tight markets, an individual buyer can drive up prices precisely because the trade is tight. That’s the pump part, but the problem is always that in a thin market, the dump drives prices down and there’s no money in the aggregate. But if the pump is in the overnight market, liquidated in the more liquid day market, then it could – could! – work. Opinions on this are, one might say, undecided.
It is, finally and very annoyingly, possible to go back to the beginning of the academic note of this oddity and think back to what was originally said. Because it was noted when overnight trading became a reality, in the early 1990s. Prices go up after the markets close, before they open, now why the hell is that?
This boring answer is that most price movement information happens outside of business hours. Therefore, market prices move more outside of hours than within hours. There is something almost obvious about this. If you monitor the London Stock Market News Service, for example, most announcements take place between 7am when the service opens and 8am market time. The corresponding flood of information for US markets usually occurs – not always, but usually – after the market closes at 4 p.m.
So, the reason markets move outside of business hours is because information that changes market prices comes in outside of business hours. And, well, isn’t that a shock?
Now, how trading strategies are designed considering all these alternatives depends on who is doing the trading. The observation itself, markets move more outside of hours than within them, is true. But the why is important as to how a strategy for trading the entire market depends on which explanation rings true.
The one and only entirely true lesson to be drawn from this academic observation is that day trading isn’t quite the thing. Evening trading might be morning trading, but it’s only on the day when the markets are fully open that much of the price movement that makes trading potentially profitable is missing.