Ask any trader about early morning trading, and inevitably you‘ll get either a grunt or groan. This is because early AM trading is often viewed as “dangerous” as the prevailing thought is “the markets aren’t very liquid at that particular time.”
On the contrary, there is ample opportunity to profit in the early hours, and you’re leaving money on the table if you don’t chase it.
While it is true that there is more liquidity due to volume during normal session hours (9:30 a.m. to 4 p.m., EST), this also means there is more volatility in terms of economic news, geopolitical events, etc., that serves to distort the true market potential. The other concern is early morning trading is financially risky because it’s easier to get stuck in a bad position. Today, with electronic trading and overnight desks at brokerage firms, this is highly unlikely. If your brokerage firm can’t accommodate your overnight trading with simple safeguards, than consider another firm.
For many, early morning trading is preferable—say, starting at 4 a.m. (EST). For some, the less-volatile markets and relative calmness provide a clearer picture of direction. Asia has either finished trading (or very soon will have finished) and Europe is just starting to trade. With Europe trading for about an hour by this time, it’s easier to gauge where the market has been and where it may be going direction wise.
And the negatives of off-hour trading can be turned to positives. For instance, the largest concern is lack of liquidity, which can cause an unusually large market move. Traders can wait for this and when there appears to be no fundamental or technical justification for this, a trade can take the other side on a mini reversion to the mean play turning a lack of liquidity into an advantage. This trade can be confirmed by looking at anomalies if correlated and negatively correlated markets.
“Morning moves” (below) shows the crude oil (CL) contract on Friday, Sept. 5, at 4 a.m. (EST). A blue arrow indicates the beginning of upward pressure on price at that time. Given that crude is negatively correlated to the U.S. dollar, let’s look at the U.S. Dollar Index for confirmation.
“Following the money” (below) shows the price action in the U.S. at the same time and on the same date. Notice what happened to its value. It fell, indicated inverse correlation and confirming the move in crude oil. (Note that the crude contract month shown here is October, while the front month for the U.S. dollar index at this time is September.)
This relationship isn’t only apparent in the crude oil market. You also can see it at work in other currencies as well as Treasuries. The 30-year T-bond futures contract (ZB) is another good market to explore for opportunities to trade in the early morning hours.
In “Bonds away” (below) we show the December contract. Notice what happened at 4 a.m. (EST) in the bond market. The 30-year bond futures contract rose in value as the U.S. dollar depreciated. Once again, these are reverse correlated assets. Each tick on the 30-year bond futures is worth $31.25. It usually appreciates anywhere from five to nine ticks at this hour.
When related markets move in concert in this fashion, it creates more certainty that the move itself will persist. Assuming an accommodating position is supported by your other analysis, confirming moves should give you additional confidence in holding or adding additional contracts.
As stated, another reason to consider trading at this hour is less volatility. Because fewer institutions are trading in the early hours, we’re less likely to see moves that confound common economic assumptions.
Indeed, the summer of 2014 had trading sessions during which the markets should have gone up (based on traditional analysis of fundamental news breaking at the time); however, the opposite happened.
For example, on Friday, Sept. 5, nonfarm payroll numbers were reported for August 2014. The actual number of new jobs created came in at 142,000 vs. the much higher expected number of 226,000. Because many fewer jobs were created than were anticipated, it could be viewed as a sign of weakness in the economy. Traditional analysis would suggest that this should apply downward pressure on the stock market.
However, while the markets initially fell when this news broke, the Dow Jones Industrial Average ultimately closed higher by 67 points during the regular trading sessions. We can perform some post-move analysis to infer why. Perhaps the market felt that the weaker employment numbers would make it harder for the Federal Reserve to justify hiking interest rates; therefore, easy credit and the economic stimulus that comes with it will persist for longer. If the numbers had been on par with the positive expectations, perhaps they would have allowed the Fed to start tightening credit in an effort to head off inflation.
We’ve seen many times this past year the same phenomena at play, where the markets rise on weaker-than-expected economic news. This is the type of unpredictable behavior that is common during regular trading hours. As traders, we can avoid this uncertainty by focusing our efforts on early morning hours when market relationships play out absent large institutional interests that can shift bias counter to our expectations.
Nick Mastrandrea is the author of Market Tea Leaves. Market Tea Leaves is published daily, pre-market in the United States, and can be viewed at www.markettealeaves.com.