Two Ways to Increase the Probability on Early Morning Trades

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Two Ways to Increase the Probability on Early Morning Trades

When trading futures, stocks, ETFs or watching indexes–directly or via a binary option–the early morning trades often present the best opportunity. When the market opens orders flood in, creating volatility and profit potential. While I’ve read some trading books that say to avoid trading near the open and close of a market because it is too volatile, I could not disagree more. On the contrary, myself and almost every other professional trader I know makes nearly all their money near the open and close. Patterns are pronounced at the beginning of the day, because the moves are sharp, swift and often of large magnitude. This can kill traders who don’t know what they are doing, but with a couple ways to increase the probability of picking good entry points, hopefully you’ll start to like the market open as much as I do.

Before you can increase your probability of find a good entry, you need a strategy. Here is a very simple one.

Before the market opens you’ll set up support and resistance zones. These are price areas at which the stock or future you’re watching is liking to reverse or “bounce” off of.

Given that we are trading the open, this is a day trade, and using a 1or 2 minute chart is recommended.

The first thing we look for is a gap in the price, from yesterday’s close to today’s open.

Figure 1 shows a gap in the S&P 500 Index, which is used for demonstration purposes.

Figure 1. S&P 500 Gap – 1 Minute Chart

Once there is a gap we place a support or resistance zone, which will be near the previous day’s close. Since the market rallied higher off the open in Figure 1, the price area around the previous close is called the support zone. If the market had fallen away from the previous close, then the price area around the previous close would be a resistance zone.

Figure 2 shows the support zone created by the previous close. I generally use the last several minutes of the previous session as the support/resistance zone.

Figure 2. S&P 500 Support Zone – 2 Minute Chart

The goal is to go long/buy calls when the price is near the support the zone. Similarly, go short/buy puts when the price is near the resistance zone. In the case of Figure 2, we’d be buying calls…but when? That is where the probability enhancers come in.

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Enhancer # 1: Make Sure the Price Leaves the Zone Before Making a Trade

Look back to Figure 2. In real-time the price could easily keep falling right through the support zone we’ve drawn. The support zone is a price area I usually expect the market to stall and reverse–near the previous close after a gap–but that doesn’t mean it always will.

Therefore, wait for the price to enter the support/resistance zone, or just touch it, and then begin moving away from it before taking a trade. So In figure 2, you’d commence the long/call trade once the price is moving higher out of the support zone. This shows that at least temporarily the support zone is holding and the price is likely to rise. Figure 3 shows a zoomed in version of the prior charts. It shows the entry occurs as the price moves back out of the zone, as the zone looks like it will cause a reversal. If the price falls right through the zone, no trade is taken.

Figure 3 – Entry Point

In the case of a resistance zone, you’d enter short/buy puts once the price begins to fall back away from the resistance zone.

Enhancer # 2 – The Reversal Should Occur Quickly

In Figure 3 the price enters the support zone and within a couple bars it is already moving back out. While this support zone is relatively small–only about 1 point–some days the zone will be much bigger due to volatility near the close on the previous day (remember, the zone is created based on the last few bars at the previous close). Regardless of how big or small the zone is, the price shouldn’t stay in the zone for long. We want the price to bounce off the support or decline off the resistance zone within several minutes of getting close to it.

The sharper the reversal near the zone the better. Take Figure 3 for example. At a support zone you are expecting buying interest to enter the market, so if the price moves sharply higher near a support zone it shows that indeed there is buying interest there and going long/buying calls is the right choice. Similarly, at a resistance zone you expect selling/shorting, so when the price declines sharply off the zone it shows there is selling pressure and you want to be short/buying puts.

These Enhancers Can Be Used For Other Strategies

While these enhancers have been applied to a simple trading strategy for the purposes of this article, the enhancers are useful in many other strategies as well.

As for enhancer one, I almost always wait for the price to begin moving in the direction I want before making a trade. I never assume that support/resistance zones or levels will hold; only once the price respects the level or zone do I take my trade. Wait for price to confirm your technical analysis; don’t just assume the price will do what you want, when you want.

As for the second enhancer, if you have a strong support or resistance zone–based on whatever strategy or analysis method you’re using–and the price reverses aggressively off that zone, the odds are good the reversal will continue at least for the short-term.

Trade with the aggressive traders when they respect a support/resistance level.

How to Get a 10 Percent Monthly Return Day Trading

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For most people who start day trading, the ultimate goal is to quit their job and be able to make a living off of the markets. There are two ways to make a living from day trading.

  1. You could start with a large amount of capital and make a small percentage return to produce a decent monthly income. This requires more capital but less skill.
  2. The other option is to start with a smaller amount of capital, say $10,000 to $30,000, and generate higher returns in order to make a living. This requires less capital, but much more skill.

Below is a blueprint for ramping up your returns to 10 percent or more per month. That way, even if you are starting with $10,000, you’ll be making at least $1,000 per month, and that income will grow as your capital and/or returns grow.

Whether you day trade stocks, forex, or futures, align your trading process around the tactics discussed below. With hard work and practice, over the course of six months to a year, you just may be able to become one of the few traders (relative to those who try) who make a living from day trading.

Day Trading Success and How Long It Takes

Before you can day trade for a living, know what you are up against. Day trading lures throngs of people, yet most of these people won’t make a profit, let alone a living. Most people who attempt day trading will lose most, or all, of the money they deposit into their trading account.

Less than 4.5 percent of day traders who try will be able to make a living from day trading. The chance of making a great living is much smaller. For the 4.5 percent that makes a living from the markets, it typically takes them six months to a year—dedicating full-time hours (about 30-40 hours per week) to education, practice, and trading—before they reach that level.

The blueprint that follows will help you be one of the few traders who can make a living off day trading, potentially pulling returns of 10 percent or more out of the market each month.

Day Trading Success Reduced to Four Numbers

Create or follow a strategy that allows you to keep these numbers in the target zones, and you will be a profitable trader. Successful trading can be reduced to four factors: risk on each trade (position size), win-rate, reward-to-risk and how many trades you take.

Understanding these four numbers will help you reach your goal of day trading for a living. All the components/numbers work together. Here’s how:

Capital at Risk per Trade

To be successful, control the risk on each trade. Risk a maximum of one percent of your account on each trade. For example, if you have a $10,000 account, risk up to $100 on each trade.

Place a stop loss order to make sure you don’t lose more the one percent of your account. Once you know your entry price and stop loss level, calculate your position size (how many shares, lots or contracts you take in the stock market, forex market or futures market).

One percent may not seem like a lot to risk, but, as I’ll explain in the next section, our winning trades should always be bigger than our losing trades. While we only risk one percent, we strive to make 1.5 percent to three percent on our winners, risking $100 to make $150 to $300, for example. Only risking one percent also means that even if you hit a losing streak of five to 10 trades, you haven’t lost much capital. A few winning trades and you have made that loss back. Risk more than one percent though, and a losing streak can decimate your account.

Reward:Risk

The reward:risk is how much you make on winning trades relative to how much you lose on losing trades. If you are always risking one percent of your capital, then your reward-to-risk should at a minimum be 1.5:1. That means you are making 1.5 percent (or more) on your winning trades, and losing one percent on your losing trades.

To accomplish this, place a profit target that is a greater distance from your entry point than your stop loss is. For example, if you buy a stock at $10 and place a stop loss at $9.95 (this risk would represent approximately one percent of your account capital, based on your position size) then your target would need to be placed near $10.08. If you lose, you lose $0.05 per share, but if you win, you make $0.08. That is a reward:risk of 0.08:0.05, or 1.6:1. Reward:risk is interlinked with the win-rate.

Win-Rate

The win-rate is how many trades you win, expressed as a percentage. If you make 100 trades in a demo account and win 53 of them, your win-rate is 53 percent. Win-rate is interlinked with reward:risk.

Day traders should strive to keep their win-rate near 50 percent or above; that way, if the reward:risk on each trade is 1.5:1 or above, you will be a profitable trader.

Assume you are able to maintain a 1.5 reward-to-risk over 100 trades. You are adding 1.5 percent to your account on winners, and losing one percent of account capital on a loss.

If you win 50 percent of your trades, you are in good shape: 50 x 1.5 percent = 75 percent – (50 x 1 percent) = 25 percent. You increase your account capital by 25 percent over those 100 shares. If you win 40 percent of your trades, then you don’t make any money: 40 x 1.5 percent – (60 x 1 percent) = 0 percent.

See how win-rate and reward:risk are linked? If you only win 40 percent to 50 percent of your trades, try to bump it up to 50 percent or more by making small changes to your strategy. Alternatively, you could try to reduce risk slightly or increase your reward slightly to improve your reward:risk. Slight adjustments could push this break-even or losing strategy toward being a profitable one.

Number of Trades

From the numbers above, your goal is to win more than 50 percent of your trades and make 1.5 percent or more relative to the one percent you are risking. If you can do that, the more trades you take that still allow you to maintain those statistics, the better.

If you make one trade per day, that is about 22 trades per month. If you win 50 percent with a 1.5 reward:risk, you make 11 x 1.5 percent – (11 x 1 percent) = 5.5 percent. If you make two trades per day, you win 22 trades and lose 22 trades, but your percentage return increases to 11 percent for the month.

If you only trade a two-hour period—which is all that is required to make a living from the markets (this is the end result, at the beginning you will want to put in at least several hours per day of study and practice)—day traders should be able to find between two and six trades each day that allow them to maintain the statistics mentioned above. Note that some days produce no trades because conditions aren’t favorable, while other days may produce 10 trades. At an average of four trades per day, if you maintain the above stats, you’ll generate a return of 22 percent on your capital for the month.

Don’t take trades for the sake of taking trades though; this will not increase your profit. All trades taken must be part of a strategy that allows you to win 50 percent or more, with a 1.5:1 or greater reward:risk. If you take trades with a poor probability of winning, or where the reward doesn’t compensate for the risk, this will drag down your statistics, leading to a lower return or a loss.

Tying All the Statistics Together

If any of these statistics get out of whack, it will hurt your results. It’s a razor-thin line between profitable trading and losing. Over 100 trades, winning 50 means a nice income, while winning only 40 means you break even or lose money when accounting for commissions.

A slight drop in win-rate or reward:risk can move you from profitable to an unprofitable territory. Risking too much on each trade can decimate your account quickly if you hit a losing streak. Winning 50 percent of your trades doesn’t mean you will always follow the pattern of win, lose, win, lose, win. Wins and losses are distributed randomly. Some days you may lose all the trades you take, while other days you may win them all. There is no specific number of trades you should, or need, to take each day. However, over many days, it should average out to at least two trades or more a day if you want to eclipse the 10 percent-per-month return mark.

The only way to know if a strategy can produce the numbers above (or better) is to test that strategy out in a demo account. Take hundreds of trades, and if the strategy produces the results above (or better) then you have some assurance—but no guarantees—that the strategy can produce those figures in the future. Small adjustments may be required over time to keep the strategy aligned with the numbers above. If a strategy produces those numbers, then only trade that strategy. Don’t trade any strategy that is untested, as untested strategies typically drag down your win-rate and/or reward:risk.

Which Market to Day Trade

The statistics above apply whether you trade stocks, forex or futures—the main day trading markets. Your percentage returns will be similar in each if you create or follow a strategy that maintains the statistics above. Which market you choose shouldn’t be based on return potential, as they all offer similar returns. Rather, base your decision on which market you are most interested in and the amount of starting capital you have.

To day-trade stocks, you need at least $25,000. If you have less than $25,000 in trading capital, save up more capital, or day trade futures or forex. For day trading futures, start with at least $7,500. For day-trading forex, start with at least $500. Your initial trading capital is a major determinant of your income. If making 10 percent per month, with a $25,000 account you will make $2,500 in income (less commissions). With a $500 account, you will make $50 (again, less commissions).

Choose the market you are most interested in that allows you to trade with the capital you have available. The less capital you have, the longer it will take to build up your capital to a point where you can make a livable monthly income from it.

The More Capital, the Harder It Is to Maintain High Percentage Returns

Making 10 percent to 20 percent is quite possible with a decent win-rate, a favorable reward:risk ratio, two to four (or more) trades each day and risking one percent of account capital on each trade. The more capital you have, though, the harder it becomes to maintain those returns.

If you are trying to day trade millions of dollars, it is much harder to make 10 percent a month than it is for someone trading a $75,000 account. There is only so much buying and selling volume at any given moment; the more capital you have, the less likely it is that you will be able to utilize it all when you want to. This is typically why only individuals or very small hedge funds can generate huge yearly returns, yet these returns are unheard of when discussing traders or hedge funds with very large accounts.

Final Word on Making 10 Percent Per Month From Day Trading

The math works, and there are many strategies-freely available—that provide more than two-day trades a day, a greater than 50 percent win-rate, and a reward:risk greater than 1.5:1. Keeping your risk to one percent or less is up to you and should be employed no matter which strategy you use.

The main problem is that while you can see the math works over 10 or 100 trades, while you are in a trade it is very hard to remember the big picture. Most new traders can’t stand losing, and so they exit a winning trade with a tiny profit, messing up their reward:risk. They hold onto a loser, not wanting to accept the loss, and end up losing much more than one percent on a single trade. This also messes up the reward:risk, and could potentially decimate the account.

New traders also need to remember that wins and losses are not evenly distributed. You may win or lose several trades in a row. A winning streak doesn’t mean you are a phenomenal trader and can abandon your strategy. Likewise, a losing streak doesn’t mean you are a bad trader. The only thing that matters is how many trades you win and lose out of 100, which is about how many trades you will take each month. Win more than 50 with a reward to risk of 1.5:1 and you will be a very profitable trader, even if you had a few days in a row where you lost every signal trade you made.

Make hundreds of day trades in demo account using the same strategy to see the win-rate, reward:risk and number of trades per day it produces. Only utilize real capital once you have hundreds of trades worth of data, and the strategy is showing a profit over those hundreds of trades.

Scalping: Small Quick Profits Can Add Up

Scalping is a trading style that specializes in profiting off small price changes, generally after a trade is executed and becomes profitable. It requires a trader to have a strict exit strategy because one large loss could eliminate the many small gains the trader worked to obtain. Having the right tools such as a live feed, a direct-access broker and the stamina to place many trades is required for this strategy to be successful.

Read on to find out more about this strategy, the different types of scalping and for tips about how to use this style of trading.

How Scalping Works

Scalping is based on an assumption that most stocks will complete the first stage of a movement. But where it goes from there is uncertain. After that initial stage, some stocks cease to advance while others continue.

A scalper intends to take as many small profits as possible, without letting them evaporate. This is the opposite of the “let your profits run” mindset, which attempts to optimize positive trading results by increasing the size of winning trades while letting others reverse. Scalping achieves results by increasing the number of winners and sacrificing the size of the wins. It’s not uncommon for a trader with a longer time frame to achieve positive results by winning only half or even less of his or her trades – it’s just that the wins are much bigger than the losses. A successful scalper, however, will have a much higher ratio of winning trades versus losing ones, while keeping profits roughly equal or slightly bigger than losses.

Scalping: Small Quick Profits Can Add Up

The main premises of scalping are:

  • Lessened exposure limits risk: A brief exposure to the market diminishes the probability of running into an adverse event.
  • Smaller moves are easier to obtain: A bigger imbalance of supply and demand is needed to warrant bigger price changes. For example, it is easier for a stock to make a 10 cent move than it is to make a $1 move.
  • Smaller moves are more frequent than larger ones: Even during relatively quiet markets, there are many small movements a scalper can exploit.

Scalping can be adopted as a primary or supplementary style of trading.

Spreads in Scalping vs. Normal Trading Strategy

When scalpers trade, they want to profit off the changes in a security’s bid-ask spread. That’s the difference between the price a broker will buy a security from a scalper (the bid) and the price the broker will sell it (the ask) to the scalper. So, the scalper is looking for a narrower spread.

But in normal circumstances, trading is fairly consistent and can allow for steady profits. That’s because the spread between the bid and ask is also steady, as supply and demand for securities is balanced.

Scalping as a Primary Style

A pure scalper will make a number of trades each day — perhaps in the hundreds. A scalper will mostly utilize tick, or one-minute charts since the time frame is small, and he or she needs to see the setups as they shape up in as close to real-time as possible. Supporting systems such as Direct Access Trading (DAT) and Level 2 quotations are essential for this type of trading. Automatic instant execution of orders is crucial to a scalper, so a direct-access broker is the preferred weapon of choice.

Scalping as a Supplementary Style

Traders with longer time frames can use scalping as a supplementary approach. The most obvious way is to use it when the market is choppy or locked in a narrow range. When there are no trends in a longer time frame, going to a shorter time frame can reveal visible and exploitable trends, which can lead a trader to scalp.

Another way to add scalping to longer time-frame trades is through the so-called “umbrella” concept. This approach allows a trader to improve his or her cost basis and maximize a profit. Umbrella trades are done in the following way:

  • A trader initiates a position for a longer time-frame trade.
  • While the main trade develops, a trader identifies new setups in a shorter time frame in the direction of the main trade, entering and exiting them by the principles of scalping.

Based on particular setups, any trading system can be used for the purposes of scalping. In this regard, scalping can be seen as a kind of risk management method. Basically, any trade can be turned into a scalp by taking a profit near the 1:1 risk/reward ratio. This means that the size of the profit taken equals the size of a stop dictated by the setup. If, for instance, a trader enters his or her position for a scalp trade at $20 with an initial stop at $19.90, the risk is 10 cents. This means a 1:1 risk/reward ratio will be reached at $20.10.

Scalp trades can be executed on both long and short sides. They can be done on breakouts or in range-bound trading. Many traditional chart formations, such as cups and handles or triangles, can be used for scalping. The same can be said about technical indicators if a trader bases decisions on them.

Three Types of Scalping

The first type of scalping is referred to as “market-making,” whereby a scalper tries to capitalize on the spread by simultaneously posting a bid and an offer for a specific stock. Obviously, this strategy can succeed only on mostly immobile stocks that trade big volumes without any real price changes. This kind of scalping is immensely hard to do successfully, as a trader must compete with market makers for the shares on both bids and offers. Also, the profit is so small that any stock movement against the trader’s position warrants a loss exceeding his or her original profit target.

The other two styles are based on a more traditional approach and require a moving stock where prices change rapidly. These two styles also require a sound strategy and method of reading the movement.

The second type of scalping is done by purchasing a large number of shares that are sold for a gain on a very small price movement. A trader of this style will enter into positions for several thousand shares and wait for a small move, which is usually measured in cents. Such an approach requires highly liquid stock to allow for entering and exiting 3,000 to 10,000 shares easily.

The third type of scalping is considered to be closer to the traditional methods of trading. A trader enters an amount of shares on any setup or signal from his or her system and closes the position as soon as the first exit signal is generated near the 1:1 risk/reward ratio, calculated as described earlier.

Tips for Novice Scalpers

With low barriers to entry in the trading world, the number of people trying their hands at day trading and other strategies such as scalping has increased. Newcomers to scalping need to make sure the trading style suits their personality because it requires a disciplined approach. Traders need to make quick decisions, spot opportunities and constantly monitor the screen. Those who are impatient and feel gratified by picking small successful trades are perfect for scalping.

That said, scalping is not the best trading strategy for rookies, as it involves fast decision-making, constant monitoring of positions and frequent turnover. Still, there are a few tips that can help novice scalpers.

  • Order execution: A novice needs to master the art of efficient order execution. A delayed or bad order can wipe out what little profit was earned and even result in a loss. Since the profit margin per trade is limited, the order execution has to be accurate. As mentioned above, this requires supporting systems such as Direct Access Trading and Level 2 quotations.
  • Frequency and costs: A novice scalper has to make sure to keep costs in mind while making trades. Scalping involves numerous trades — as many as hundreds during a trading session. Frequent buying and selling are bound to be costly in terms of commissions, which can shrink the profit. This makes it crucial to choose the right online broker. The broker should not only provide requisites like direct access to markets, but also competitive commissions. And remember, not all brokers allow scalping.
  • Trading: Spotting the trend and momentum comes in handy for a scalper who can even enter and exit briefly to repeat a pattern. A novice needs to understand the market pulse, and once the scalper has identified that, trend trading and momentum trading can help achieve more profitable trades. Another strategy used by scalpers is a countertrend. But beginners should avoid using this strategy and stick to trading with the trend.
  • Trading sides: Beginners are usually more comfortable with trading on the buy-side and should stick to it before they gain sufficient confidence and expertise to handle the short side. However, scalpers must eventually balance long and short trades for the best results.
  • Technical analysis: Novices should equip themselves with the basics of technical analysis to combat increasing competition in the intra-day world. This is especially relevant in today’s markets dominated by high-frequency trading, as well as the increasing use of dark pools.
  • Volume: As a technique, scalping requires frequent entry and exit decisions within a short time frame. Such a strategy can only be successfully implemented when orders can be filled, and this depends on liquidity levels. High-volume trades offer much-needed liquidity.
  • Discipline: As a rule, it is best to close all positions during a day’s trading session and not carry them over to the next day. Scalping is based on small opportunities that exist in the market, and a scalper should not deviate from the basic principle of holding a position for a short time period.

The Bottom Line

Scalping can be very profitable for traders who decide to use it as a primary strategy, or even those who use it to supplement other types of trading. Adhering to the strict exit strategy is the key to making small profits compound into large gains. The brief amount of market exposure and the frequency of small moves are key attributes that are the reasons why this strategy is popular among many types of traders.

Anyone that has ever stared at a stock chart on their monitor in anticipation of the opening bell will know that stocks don’t open at the same price that they close. Most charting software doesn’t incorporate after-hours and pre-market price action, and therefore most charts look like this:

Netflix is notoriously active in the Q2 reporting period pre-market session.

As soon as one starts diving further into the realm of extended-hours trading they start asking a lot of questions. Does a stock that is increasing in price during pre-market continue to increase during the day? Should I short Tesla if it has a bad earnings report? Will the S&P500 stay positive if it’s already increased in pre-market?

We can answer this by studying historical pricing data using Python. All the code from this post is available on Github.

Objectives

Let’s try to discover if pre-market prices have any predictive qualities. Is it possible to build a successful trading system using stock performance in extended-hours.

  1. How important is pre-market price action relative to intra-day performance?
  2. What is the probability that a select stock increasing in pre-market will also increase throughout the intraday session?
  3. What’s the probability that a stock trending in pre-market will continue to trend in the same direction during intraday trading?
  4. What effect does earnings season have, are pre-market trends following announcements stronger or weaker indicators of intraday prices?

Data Collection & Methodology

The goal is to examine whether pre-market movements are indicative of intraday price action, to what extent can price action inform our investment decisions. For this we will need to define certain conditions, determine which variables we will analyze, outline our methods, and ultimately build a program that will output some results.

Defining Pre-Market

Pre-market and after-hours trading are two sessions that occur before and after the main intraday session, respectively. Traditionally, we would look at these two sessions individually, because they are separated by an 8-hour “dead” period, where no trading occurs. Pre-market runs from 4:00 to 9:30, after-hours runs from 16:00 to 20:00, and between 20:00 and 4:00 there is no trading. Pre-market and after-hours are very similar, with the same market participants and liquidity profiles. They also both play host to earnings announcements during company reporting cycles, which means this is when most price-action will occur following an announcement.

Instead of examining what happens within these sessions on an individual level, we like to think of the pre-market holistically as the time between the day’s close, and the next day’s open; 16:00 – 9:30. Regardless as to whether the company reports in after-hours or pre-market, the intraday session always follows later. We will therefore be examining the pre-market holistically, and analyzing the reactionary price action in the following intraday session.

Data Collection

For data collection we used Ramaroussi’s Yahoo! Finance Python library, which allows us to fetch historical price data for individual stocks. We made the sample of stocks the S&P 500 and Nasdaq 100 constituents, which aren’t as thinly traded as Russel 3000 components.

We used the historical data based for the trailing 5 years of each security. It is possible to complete this analysis without including pre-market and after-hours price data, by simply using the difference between the market open and the previous day’s close, so any EOD data source would be acceptable.

A component of this analysis considers the price action differences associated with reporting periods. À la post announcement drift, stocks tend to exhibit higher volatility and returns in the time leading up to and shortly following an earnings report. It was important that we find a data source that would allow us to quickly identify reporting periods within our five year sample period. For this we used the U.S. Securities and Exchange Commission’s EDGAR database. While the SEC offers a free API that can be used to fetch results, you can also scrape filings using Beautiful Soup 4, which is what we have done.

Juxtaposing the reporting dates over the 5 year performance allows us to analyze the price-action resulting from shifts in information crucial to understanding the price-discovery process. For the purpose of this study we ruled out companies that have IPOed in 2020, because of the small sample size.

Results

For the first test, we examine how much does pre-market activity contribute to total (close-to-close) price action.

Since we want to focus on the SP500 and Nasdaq 100 constituents we will initiate the first test by passing a list of symbols through the function.

We find that on average pre-market trading contributes 36.68% to absolute daily price action in the sampled stocks.

The histogram below offers a visual representation of the attributable pre-market price action of the individual stocks. This clearly shows that a significant part of price movements occur outside of regular trading hours.

Moving further, we now aim to determine whether a stock that is increasing in value during pre-market will continue to increase through intraday. After all, this is the determining factor in whether you should buy a stock that has popped overnight.

We use the function below and pass the SP500 and Nasdaq stocks as arguments in a list.

We find that on an aggregate level, a stock increasing in value during pre-market has a 50.77% probability of maintaining it’s price action during through the regular session. This is interesting because it suggests that there is close to no correlation, and the odds that stock will continue to increase are as good as flipping a coin. Some would argue that this is a great testament to the efficiency of a market in that this showcases an anti-persistent property.

With that said, there are still stocks that lend themselves to more predictability, as presented below.

The previous test took into account only positive price action, and now we must test whether pre-market price action is at all indicative of intraday performance. This means we want to consider events where the pre-market action and intraday performance were both either positive or both negative. Similar to how investors use fair-value trading strategies with pre-market futures.

We apply the next function, passing the same sample of stocks as an argument.

We find that a pre-market activity is indicative of intraday performance 49.65% of the time. Which means that it is actually statistically more likely for the market to do the opposite of what it’s done in pre-market.

This doesn’t leave us with any actionable results. Examining individual markets shows little deviation from the mean, and there are few stocks that show any indicative behavior in pre-market.

Surely, there must be time when stocks move in a more predictable way with respect to pre-market. In the final test, we aim to run through the same statistics, but we will change the sample to include only the reactionary period that follows the quarterly reporting period.

Using the function above we will now scrape the EDGAR database for reporting dates, and pull historical returns from the following trading day.

S&P500 & Nasdaq 100 stocks increase in both pre-market and intraday, following an earnings announcement, 27.10% of the time.

Out of the four possibilities of price action between the pre-market and intraday session, 27% is in line with our expectations, given the previous results we have seen. We expect to see more correlation during reporting periods because of event’s significance warranting more investor attention. Therefore, it can be inferred that under the pressure of higher trading volume there would be more momentum in price-action, causing prices to move in the same direction.

There is a noticeably higher dispersion in the data following this test. It is important to remember that for certain stocks the number of reporting periods is less because the companies are newer to the exchange, and this plays a large role in constraining the sample.

Below we can see the top and bottom ten stocks by frequency of increases in both pre-market and intraday. A high frequency not only demonstrates that the company has performed better in the sessions following previous reports, but there is an inherent price-action consistency, and we can expect more causal attribution in further tests.

The probability of a stock increasing throughout the intraday, after having increased in pre-market is 52.4%.

Similarly to the 5 year aggregate test, we see a close to fair result in whether pre-market price action is indicative of intraday action. However, like with the previous test, there is a higher dispersion, and we are able to identify companies that lend themselves to significantly more predictability.

In the case below we are presented with 7 companies that have shown to have a perfectly indicative pre-market price action. In other words, if Broadcom Inc. (AVGO) or Disney Inc. (DIS) reports earnings and increase in pre-market, they are going to increase intraday as well.

Conversely, anytime Corteva Inc. posts earnings and increases in value in the pre-market, you would be better off shorting it.

Final Remarks

In testing whether pre-market action is indicative of intraday performance we can conclude several things.

  • Pre-market price action plays a significant role in all sampled stocks and should not be ignored.
  • On an aggregate level pre-market price action does not dictate intraday price action.
  • Select stocks have shown historically to have a more indicative pre-market price action.
  • During reporting periods stocks move with more volatility, however pre-market price action is only slightly more indicative than on a five-year historical level.
  • In the case of select stocks, reporting periods can bring out indicative pre-market behavior.
  • Specific stocks should be tested for larger time periods in order to assess the true predictability of pre-market price action, however some companies are too young to have enough reporting periods to analyze.

Keep in mind that these tests are subject to misinterpretation and price action may still be driven by unique fundamentals within the stocks that exhibited highly-indicative pre-market behavior. Additionally, past returns can be useful in approximating future price action, but do not guarantee future performance. Finally, remember that the market changes constantly, and strategies that work today may not work tomorrow, however using the takeaways from these methods of pre-market analysis can help drive better decision making.

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Open Interest – Pin the Tail, But Don’t be the Donkey!

In my travels throughout the world, I often ask people, “How many people do you know who are making money trading options?” I usually only get one or two hands raised.

I then ask them, “How many of you know people who are losing money trading options?” Typically, every hand is raised to this question. It is safe to say that most novice traders in the world are not trading options properly. If we know this, then all we have to do is find the area where most traders are making mistakes and then take the opposite position. We will then have a high probability for success in our trades.

Open interest is a statistic unique to options and futures trading. Open interest is the total number of contracts that are currently in existence and have not been offset by closing trades. This is different than volume which is the number of contracts traded for the day.

If you were to buy an option to open a position and the person who sold you the option is also opening a new position, volume would increase by one and open interest would increase by one. If you then sold your option to someone else who did not have a position, then volume would increase but the open interest would not change as you transferred your interest to someone else.

Open interest would have decreased if you had sold your option to someone who had already sold an option and was buying to close their position. Since both of you are closing positions, the option contract is not needed anymore and open interest goes down even though the transaction increases the volume reported.

Understanding open interest can seem confusing at first, but our instructors at Online Trading Academy do an incredible job at making difficult concepts easy to understand in the classroom.

Open interest is important to stock traders and investors as well as option traders. Open interest shows us where traders are putting their money. Remember that the novice traders are the ones who usually buy options. We can use the knowledge that sellers tend to make money to predict potential price movement for stocks just before the expiration of the stock options.

There is a concept in the markets called option pain. When a seller of an option sees the price of the stock move to where they would lose money, they are feeling pain. By looking at where the open interest of a stock or ETF is, we can make assumptions on the price levels where there would be a lot of pain. Where there is a large amount of open interest, there is also a large probability that the price will not close there by expiration. This is because if it does, then the sellers of those options would stand to lose a lot of money.

In an effort to profit from large option or futures positions, institutional traders will often buy or sell the underlying stock in an effort to push prices to a point where the close will benefit them. This means that the price will often close on options expiration day just above or below the price where the greatest open interest lies and the least amount of pain would be felt. There is a term for this action, pinning. These traders attempt to pin the price of the stock or ETF to profit from a derivative position.

Pinning is illegal in most exchanges in the world and traders who participate in this high volume trading in an effort to manipulate prices could face penalties. The problem is in catching the culprit and the SEC punishing them.

But does it really work? While I was in class on November 20th, options expiration for the November 2020 monthly options, I checked the open interest on the expiring options contracts for SPY and QQQ. The largest open interest in SPY calls was over 161,000 contracts at $210. There was a lot of money anticipating that prices would close below $210 that day.

On the put side, there was over 50,000 open interest on the $209 puts. This meant that prices were likely going to close between $209 and $210 for the day.

A trader who was aware of this open interest and potential pinning action could have increased their chances for trading short when prices hit $210, which happened to be a supply zone anyway. The natural location for booking profits would be near or at the $209 level.

For the Q’s, the open interest on the calls suggested that prices should close below $114 to $114.50. That is where the largest open interest happened to be.

For the put side, the open interest suggested a close above $113.

Since prices opened above this range in the morning, traders should have been looking for opportunities to short the ETF until it settled into the range suggested by the open interest.

So, what can a retail trader do about this pinning? Recognize that it does happen and either stay out of the market or trade the momentum. Trading this can be very risky as you need to be quick in your decision to enter and exit when the momentum is slowing, not reversing. It is not for everyone, but if you are prepared you may be able to profit from this pinning that occurs in the markets every expiration day.

Watching the potential pinning activity in the week before option expiration and also the open interest on the weekly options can also assist those traders looking to make profits on short-term swing trades as well.

Trades should only be entered based on supply and demand zones. The open interest information provided here is only a decision support tool. To learn how to identify the zones accurately and efficiently, visit your local Online Trading Academy office today.

December 1, 2020 Issue

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