What You Should Know about Entering Trades after the Market Closes - dummies

What You Should Know about Entering Trades after the Market Closes

By Michael Griffis, Lita Epstein

As long as you’re entering your trades during market hours, using a market order is fine; however, if you’re planning to check your charts each evening and then enter your trades before heading to work in the morning, you must use a different approach.

Otherwise you risk having your orders filled at prices that can differ significantly from the previous closing prices. To make matters worse, you may discover that your position is losing money soon after being filled.

Don’t be surprised to discover that many traders trade this way. Because of their daily schedules, they analyze stock charts in the evening and enter orders before the markets open. Unfortunately, common breakout and reversal patterns cause many traders to react in a predicable fashion. After many traders enter buy orders for the same stock, a scarcity of that stock is likely to occur just after the market opens.

Scarcity causes prices of individual stocks to rise, sometimes even dramatically, so that all those aftermarket orders are filled at prices significantly higher than the previous closing price. Making matters worse, after the buy orders are filled and buying pressure disappears, the stock price tumbles back toward the previous closing price.

Professional traders — including floor traders, market makers, day traders, and swing traders — exacerbate the problem even further. These short-term traders see the same technical analysis signals that you see, and their goal is to profit from your enthusiasm, and perhaps your inexperience, as you try to open your position.

As a result, you need to think about the tactics these short-term traders employ before you enter any positions. When they see breakout or reversal patterns, short-term traders anticipate a flurry of buying activity in that stock, and they know that few people are going to be eager sellers when a stock breaks out of a trading range.

Under those circumstances, the only way buyers can get an order filled is if they bid the price higher or accept whatever price is being asked for the stock. When that happens, the best asking price is going to be relatively high.

Someone will sell the stock to position traders but only at a relatively high asking price. Short-term swing traders and day traders, who may not even own the stock, offer those asking prices, agreeing to provide the stock to the position traders as long as the buying pressure pushes the price of the stock upward. If the short-term traders don’t own the stock, they must sell the shares short.

After the short sellers absorb all that buying pressure, the rally fades and the stock’s price falls back toward the breakout price, and that’s when short-term traders buy the stock (at prices lower than they sold it) so they can cover their short positions, or in other words, return the shares that they borrowed to sell at higher prices to the position traders. How’s that for taking a quick profit.

This scenario is at the heart of why being patient usually makes sense. By steering clear of these moments of buying pressure, you’re more likely to get a much better fill, and you find out whether enough buying interest is present to keep the stock price above the breakout price. Being patient doesn’t always work, of course.

Sometimes buying pressure drives the price higher, forcing short sellers to cover at a loss, which, in turn, drives the price even higher, resulting in a runaway stock. When that does happen, you’ll probably be left standing on the platform, watching the runaway stock as it leaves you behind. Fortunately, runaway stocks don’t happen all that often. Thus, banking on runaway stocks is a poor tactic.

Don’t chase these breakout and runaway stocks. When the cycle exhausts itself, as it ultimately must, the stock returns to a more rational price, and you can reevaluate whether your position continues to make sense. As a position trader, you can afford to be patient.