Viewpoint: Steer Clear of After-Hours Trading For Now

For the average trader, there are too many pitfalls in this still-developing marketplace.
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Is after-hours trading more trouble than it's worth?

Consider that even the people running Web sites devoted to after-hours trading warn newcomers to steer clear. For one thing, they say, you've got to cope with the risks of a new and untested medium. For another, you're bound to run across seasoned daytraders who have learned to exploit the handicaps that average investors like you and I face after hours.

If you've tried after-hours trading, you may have noticed that it can be tough to get orders filled. Liquidity tends to be low, especially if you're trading less-active issues. As R.J. Burke, Web administrator at

AfterHourTrades.com, explains: "Low volume makes trading large-cap stocks dangerous and trading small-cap stocks nearly impossible. For many of the stocks in the

Russell 2000

small-cap stock index, there are no bids or offers."

The main reason you have low liquidity after hours is obvious: Most traders shut off their computers at the market close. But when after-hours trading commences, something else happens. The market fragments. Instead of trading in a single unified market as you would during the day, you are locked within one of several electronic communications networks, or ECNs, such as

Island

,

Instinet

or

MarketXT

. Each functions as a market unto itself. It's sort of like driving in a tunnel. You know what's going on ahead of you, but you're totally unaware of the traffic in the other tunnels nearby.

For example, while you're clicking the buy icon for

Cisco

(CSCO) - Get Report

at 96 7/8 using MarketXT, you have no way of knowing if the guy trading on another ECN is getting a better price. Worse, you have no idea if what you're paying will reflect the stock's price at tomorrow's opening. Volatility goes hand in hand with low liquidity, and it can run rampant during thin after-hours trading.

So that's what you're up against -- low liquidity, murky pricing and volatility -- the precise things wily night traders have learned to exploit. How do they do it? News plays are big, says Andrew Mariathasan, president of

RealTimeTraders.com, a site that posts short news items on stocks during regular and extended-hours trading.

Here's how one form of news play can work: At 6 p.m. ET, a small group of novice traders overreacts to a disappointing earnings report and sells. In a thin market where few buy offers exist, this can exaggerate the downward price movement. Unlike during the day, when market makers and seasoned traders lend a sense of sanity to the markets, at night, panic can easily take hold. If you're a seasoned trader, you buy into that panic in the wee hours, and then sell the following morning -- when more sober heads prevail.

Short-sellers use a variation of the same technique. Say you're short

IBM

(IBM) - Get Report

on a bad day, and it continues to drop after the regular market close. After hours might be a good time to cover your position. Tomorrow the price might well rise -- this time as bargain hunters snatch up shares. Mariathasan believes that lots of short-sellers lurk in the after-hours markets. And their covering moves account for why stocks trading down during the day can sometimes experience a slight upsurge after the close -- only to trade down again at the next day's open.

Two lessons here: (1) If you're a short-seller, distress selling in the after-hours market can sometimes furnish the liquidity to cover your positions. (2) If you're looking to go long, don't assume that an after-hours bounce will carry through to the next day. It could just be short-sellers seeking to avoid any surprises at the next day's opening.

And if negative-minded short-sellers aren't enough, arbitrage traders can theoretically play out their guerilla tactics in the dark of night, says Gary Mednick, president of

On-Site Traders

. While the average online broker fills orders through a single ECN, people plugged into an active-trader brokerage like Mednick's have access to three or more. What's more, brokerages like On-Site also supply special software that allows traders to execute complicated orders in milliseconds -- a prerequisite for arbitrage traders who seek to exploit small price differences existing between markets before anyone else. During the day, price differences between, say, the

Pacific Exchange

and the

Philadelphia Exchange

might vary by as little as 1/16 or 1/32 of a point -- profitable only for institutional arbitrageurs trading huge orders. But at night the spreads between ECNs can widen to as much as several points. And therein lies the opportunity.

A typical arbitrage tactic is simple enough in theory. Say

Oracle

(ORCL) - Get Report

is selling at 90 1/8 on Island. There's also a bid for 90 3/8 on Instinet. Buy 1,000 shares on Island and sell them on Instinet for a $125 profit. Not bad for two second's work.

Of course, in practice, the anonymous orders on ECNs can appear and disappear like smoke. So would-be arbitrageurs can get caught holding their shares for a while. Also, after-hours arbitrage plays will work only as long as no unified pricing exists. On Oct. 25, you'll recall,

Nasdaq

began reporting after-hours pricing data until 6:30 p.m. ET. But ECNs like MarketXT stay open until 8 p.m.. Others, like Instinet, remain open round the clock. There's been talk of ECNs getting together to transmit 24-hour pricing data. But for now the best you can do is call up the Island order book (at

island.com) and use that as a reference while you also monitor prices through your regular broker.

Or maybe you think that's more trouble than it's worth.

Mednick advises people to steer clear of after-hours markets till they've got a year of solid trading experience behind them. "The average trader will be at a disadvantage for quite a while," he says.

Mark Ingebretsen is a contributing editor with

Online Investor magazine and a consultant to a major insurance company. He has written for a wide variety of business and financial publications. While Ingrebretsen cannot provide investment advice or recommendations, he welcomes your feedback at

letters@thestreet.com. One note of disclosure: He was once hired to complete a series of educational materials for MarketXT.