Skip to main content

The early bird gets the shaft

The markets may be open for only 6 1/2 hours every weekday, but online investors are trading as if the exchanges were going 24-7. Though a minuscule number of investors are trading live in the extended-hours sessions you hear so much about on CNBC–compare the tens of millions of shares traded at night to the 2 billion or 3 billion during the day–as many as 30% of all Internet stock orders are placed at night only to be executed the next morning.

Putting in your order after the bell certainly has its attractions. Instead of trying to sneak in a few minutes of stock analysis on your computer at work, you can research how to become a millionaire while watching Who Wants to Be a Millionaire at home–and click the CONFIRM ORDER button only when you’re sure that’s your final answer. And since many companies release important news once trading has stopped, what better way to capitalize on it first thing in the morning than by getting in line before you go to bed the night before?

There’s only one problem with this seemingly ideal situation: You may be setting yourself up to be ripped off.

Fact is, there’s no more dangerous time of day than the rush when the markets open. So volatile are the first minutes–as traders gauge the impact of late news while brokers unload their order backlogs–that some institutional investors sit on their hands until things shake out.

Because the backlogs throw the law of supply and demand temporarily out of whack, many stocks open as much as several dollars higher (or lower) than their closing prices the day before. In many cases, this gap (as the day-traders like to call it) has little correlation with any news, much less with where the stock trades for the rest of that day.

What’s worse, some critics charge, is that the Nasdaq middlemen known as marketmakers may take advantage of their privileged position to make a few extra bucks off the poor saps who have lined up orders in the off-hours. Since marketmakers know how many buyers and sellers have stacked up overnight, the accusation goes, it’s pretty easy for them to guess which way the stock will head in the morning. It’s like playing a game of poker where you can see some of the other players’ cards. If a marketmaker sees a preponderance of market orders to buy a certain stock piling up before the bell, for example, he can load up on that stock in the pre-opening institutional market, which helps to drive the price up. When trading opens, he can then sell the stock to his waiting customers at a price that’s higher than it would have been (a market order, after all, simply instructs your broker to get you whatever the prevailing price is)–and he pockets a nice chunk of change in the process. “You have a conflict of interest here,” says a Los Angeles attorney who often butts heads with the marketmakers. “They’re putting their interests ahead of their customers’.”

The marketmakers, for their part, deny that they manipulate the backlogs for their own gain. A spokesman for Knight Trimark, the largest marketmaker, says the company actually loses money at the open, because it pledges to execute all trades at the opening price, even if the stock goes up before it can fill all the orders.

The most surprising thing about all of this: Even if the the marketmakers did admit to the practice, they technically wouldn’t be doing anything wrong. It’s all perfectly legal. During the day, brokers are forbidden from trading ahead of their customers by something called the Manning Rule–but the rule doesn’t apply before the markets open.

So where does all this leave you? The morning madness is real, regardless of who’s really to blame, and it’s not likely to get better any time soon. The National Association of Securities Dealers is considering reforms to make the opening less chaotic, but they’re little more than vague proposals at the moment.

In the meantime, there are two ways to protect yourself. If you place a trade overnight, make it a limit order, the kind of trade where you specify the price you’re willing to pay. (This, however, is an imperfect solution, since a particularly jumpy opening may blow right past your preferred price.) Even better is to stay out of this fray entirely. Research your stock picks in your jammies all you want, but place your order the next day, after the morning traffic jam. Playing the market is tough enough without giving away your hand.