The Market that Never Sleeps

Trading in the Dark: Exploring the Relationship between RTH and Overnight Price Movements

The index CFD’s we’ve discuss here trade pretty much 24 hours a day, Monday morning to Saturday morning. But the shares on the ASX only trade from 10am-4pm, so what’s the go the rest of the time?

Basically there is a period when the underlying market (ie the ASX) is physically open (Regular Trading Hours (RTH)) and when it’s not. When people talk about ‘out of hours’ futures pricing on an index, they're usually referring to trading that happens when the stock market is closed.

During out of hours trading, the price of these futures contracts can go up or down based on things like news events, economic data, other stockmarket movements, or geopolitical developments. These events can affect the price of our shares when the stock market opens again.

For example, let's say overnight there's a big announcement about a new bilateral trade deal that's likely to benefit many of the companies in the S&P200. During out of hours trading, futures contracts on the AUS 200 might go up say, 50pts because investors are anticipating that the stock market (XJO) will trade UP when it opens again at 10am the following trading day.

Remember that the AUS200 is a derivative of the physically traded SPI futures contract, which itself is a derivative of the XJO, which is calculated based on the prices of the S&P200, the top 200 stocks on the ASX. So, if this trade deal is expected to benefit many companies, it’s reasonable to assume that these companies should be worth more following the announcement (the Net Present Value of expected future cash flows is higher), and therefore at the open auction for those companies the next trading day, simple demand / supply dynamics should mean these company’s share prices should open higher, which in turn, results in the XJO price being higher (as this is the calculated price of the ’basket’ of the top 200 companies). In this example, speculators believe that the XJO should trade 50pts higher than where it closed the previous day.

When the stock market opens, the actual price of the AUS 200 Cash will adjust to reflect how the XJO is actually trading vs expected. If the news about the trade deal is, in reality resulting in stocks being bid higher than was expected at open, the AUS200 will rally further, maybe 70pts higher than the previous day close (50 overnight + 20 in RTH). The XJO will also be up 70pts. But how quickly were the share price bid? Were they bid there on open, or were they progressively bid throughout the day? In this scenario, we would have an opportunity to short the AUS200 as it immediately adjusted down on open, then longed as it recalibrated higher.

If the ASX opens and it’s clear that investors have shrugged off the news of the trade deal, and the XJO opens flat, well the AUS200 price must immediately adjust downward 50pts, to reflect the fact that the XJO is still worth the same as it was yesterday. This is an overly simple analysis, and is complicated by many factors, including for example, the staggered A-Z ASX opening (this is why the first 10 minutes of trade is volatile, as traders attempt to ‘predict’ the correct price of the XJO, based on incomplete information as each parcel of stocks are progressively opened. We also commonly see day high and day low points here for this reason).

It’s important to stress again that the relationship between out of hours futures pricing and the RTH adjustment and price movements during market hours can be complex and unpredictable. There are many factors that can affect how the index performs, and it's difficult to predict how the market will react to any given event.

Personally, I break the trading day up into 4 distinct sessions, which all operate with unique patterns, and thus I employ different trading strategies to each. During the Day Market for example, the AUS200 essentially tracks the movements of the XJO, for which we can build a model around how those market participants (such as Retail Investors, Hedge Funds, Super Funds etc) act on a day to day basis, given certain events. While the drivers behind out of hours moves are very different, and require an understanding of another set of market participants, each with their own unique drivers.

We can dig deeper into each of these sessions at another time, but for now, just understand that the disconnect between out of hours pricing, and RTH pricing, creates excellent opportunities for traders to exploit price dislocations, which are often very easy to identify.

If you have any comments or questions, please feel free to leave below.

Cheers

Marto