Go Home Already! Your After-Hours Trading Need-to-Know List

Investing online after hours is a bit like skydiving. Even after you've researched the risks, you don't really know what it's like until there's nothing between you and the ground.

The After-Hours Club
Bell Curve: How After-Hours Trading Foreshadowed Tuesday's Ameritech Selloff

The potential pitfalls of after-hours trading have been well documented: low liquidity, wide spreads between the bid and ask prices, and savvy institutional bullies looking to take advantage of your missteps. If you're still interested, here's a look at how you can trade stocks during extended hours.

Once you choose the online broker that best suits your needs, experts suggest you review two key elements of extended hours trading you may not be familiar with: limit orders and the order book.

During regular-hours trading, you can place a market order to buy or sell a stock at the stock's current price. But there is no standard price quote on stocks trading after 4 p.m. ET, so all after-hours trades are limit orders. That is, when you place an order, you set a price ceiling for a buy and a floor for a sell.

The good news is that limit orders allow you to set parameters for your trades, which can protect you from buying higher than you'd like or selling lower than you'd like if a stock's price swings widely. The bad news is that even though after-hours trading volume is reportedly on the rise, don't be surprised if no one takes you up on your bid to buy or offer to sell, and the session closes with your order unfilled.

As its name suggests, the order book is a record of all orders currently pending on a given stock. Once your order is placed, your online broker adds it to that stock's order book on an electronic communication network, or ECN, which pairs buyers with sellers when their bid and ask prices match up.

When you trade after hours, you can see the order book on a stock before you place your order and then track your order's status. This behind-the-scenes view is markedly different from trading during the day, when most investors typically don't see pending orders.

Below is an example of an order book from Datek Online's Island ECN. Current buy and sell orders are listed in two columns, with the best (highest) buy orders and the best (lowest) sell orders first. This gives you a good idea of the stock's current spread, and the volume figures at the top of the page can give you an indication of the stock's current liquidity. When your order matches up with another order on the other side of the stock, it's executed and removed from the order book.

MSFT Order Book As of 5:13 p.m. ET Tuesday.
Source: Island

"Investors should use the order book before they trade because it can help them determine the depth of the market in a given stock," advises John Chapel, president of TD Waterhouse's (TWE Quote) Investor Services unit, which will let its clients start trading during extended hours in October.

In general, when few orders are being placed, the potential for wide bid-ask spreads and share-price swings -- both bad news for the individual investor -- goes up. Using the order book to measure a stock's price range and liquidity can help investors avoid situations where they could get burned.

An After-Hours Trader's Checklist
COMPARE a stock's standard-hours closing price with its current after-hours price. Less liquidity can lead to sharp share-price swings, and you need to know if a stock you want to trade has gone crazy after hours.
STUDY the order book carefully, looking for wide bid- ask spreads or a glut of buyers or sellers. A crowd on the buy or sell side can be an indication the stock price is headed up or down. When buyers outnumber sellers the price should rise, and too many sellers usually send a stock's price south.
READ that day's news on the stock you're trading, including after-hours announcements. The thinness of the after-hours market makes it susceptible to overexuberant reactions to breaking news. This can be helpful because you can profit from overreactions. But if you can't find a reason for upward or downward momentum, you might want to hold your order until you can get a handle on what's driving a stock's movement.

As expected, liquidity has been an issue in after-hours trading since Datek first offered an extended session on July 20. Most firms refuse to disclose trading statistics, particularly share-volume figures, but Datek reports that this past Monday it executed just 53 trades of Microsoft (MSFT Quote) shares, for example, in its after-hours session. Despite such a modest figure, which represented 5% of Datek's total trades that evening, Dunn says liquidity hasn't been an issue for investors trading Microsoft or other large, popular stocks: "It's really only a concern with more obscure issues."

Some online brokers, including Dreyfus Brokerage, a unit of Mellon Bank (MEL Quote), and Discover Brokerage, a unit of Morgan Stanley Dean Witter (MWD Quote), have sacrificed breadth for better liquidity by limiting after-hours trading to the Nasdaq 100 and S&P 100, which include some of the largest and most actively traded stocks.

Still, Chapel advises after-hours investors to expect greater price volatility on most stocks due to modest volume. But Datek spokesman Mike Dunn expects this concern to erode over time. "Liquidity has been good for the more active names and broader liquidity is building," he says. "Already 2% of our trades are placed after hours."

Apparently others are noticing. On Aug. 20, the Chicago Stock Exchange announced that on Oct. 1 it will extend trading on 250 to 300 of the most active stocks to 6:30 p.m. EDT. Investors who develop a taste for after-hours online trading will be glad to hear that if volume continues to rise, Datek may expand its trading hours even further beyond its current 5:15 p.m. EDT closing, according to Dunn.

Look out, must-see TV.