Using Correlation in Extended Hours Trading

The previous Active Trading blog examined risks and preparation for extended hours trading. Now, a strategy for pre-market and after-hours trading is examined.

Extended hours trading can be potentially profitable, in part because high frequency traders are not active. However, traders need to be aware that this lack of volume, along with less activity from human traders, significantly elevates risk.

Stocks Not Moving As History Suggests?

  • By being aware of the broader market and a company’s peers, traders have the opportunity to find stocks that have not moved as history suggests they should.

Correlation & The Broad Equity Market

  • The most basic way to examine correlation is with the broad equity market. For example, if a stock has a beta of two (correlation with the market as a whole calculated with regression), and S&P 500 futures are up one percent, past price performance says the stock should be up two percent. High probability bets can be found simply by finding situations where shares are not moving as they typically do with the market. Index futures are most reliable near the market open and close as volume increases.
  • Although market correlation is important, traders can get a better sense of a stock’s future movement by noting peers. This is especially true for industries that move closely together (ie. powercell industry, solar). Many have been successful by finding stocks that are moving on fundamentals, but peers are yet to react. For example, a positive market outlook (which would be bullish for similar companies) to stolen market share (which would be bearish for competitors). The strength of the signal is elevated if other peers are moving on the news.

Other popular areas of correlation include commodities and foreign markets.

  • A significant amount of risk can be taken out of these strategies with hedging. A basic method is to short the security that is steeply higher while buying the unchanged security, and vice versa when the security shoots lower. In order to be profitable, traders do not need to pick the direction of the stocks. Rather, one stock needs be overreacting while the other is under reacting, or one assumption is correct and the magnitude of the move is larger.

One of the biggest challenges with utilizing this strategy is finding another stock symbol to serve a trading partner. To overcome this, traders should look for securities that typically have a tight bid ask spread in extended hours trading (often more stable companies or ones that see high volume), or stocks resting on key technical levels.

Lime Brokerage LLC is not affiliated with these service providers. Data, information, and material (“content”) is provided for informational and educational purposes only. This content neither is, nor should be construed as an offer, solicitation, or recommendation to buy or sell any securities. Any investment decisions made by the user through the use of such content is solely based on the users independent analysis taking into consideration your financial circumstances, investment objectives, and risk tolerance. Lime Brokerage LLC does not endorse, offer or recommend any of the services provided by any of the above service providers and any service used to execute any trading strategies are solely based on the independent analysis of the user.

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