Evening Trading May Raise Risks for Individuals

Individual investors know the drill all too well.

The stock market closes at 1 p.m. Pacific time, and five minutes later a company announces poor quarterly earnings. As institutions dump the stock in after-hours trading, individuals are stuck on the sidelines.

By the time individuals can trade the next morning, the share price already has tanked.

However, with last week’s vote to extend trading hours on the Nasdaq Stock Market, individuals may finally get a shot at the after-hours markets. Nasdaq, the New York Stock Exchange and several private companies are all expected to start after-hours sessions later this year.

After-hours trading may turn out to be an important advance for individual investors. By trading in the evening, individuals may avoid the crush of overnight orders that are filled each morning. Theoretically, that could help some people secure better prices on stock trades.

However, in the short term, individual investors should be careful about what they wish for.

At least initially, evening trading could be far riskier than daytime trading. Stock prices can be more volatile and spreads between bid and ask prices can be wider. That means unwitting individuals could end up with far worse executions than if they had waited until the next day to trade.

And, ironically, individuals still won’t be able to respond as quickly as institutions to late-breaking news.

The concern regulators have for individuals was evident a couple of hours after Nasdaq’s parent organization, the National Assn. of Securities Dealers, voted to extend trading hours. That’s when Securities and Exchange Commission Chairman Arthur Levitt warned investors about the risks.

Wall Street firms “should inform retail investors in particular about after-hours liquidity and volatility conditions so investors can make an informed choice” about after-hours trading, Levitt said.

“The fear is the markets are going to be thinner, the spreads are going to be wider and the volume is going to be worse,” said Gene Noser, president of Abel/Noser Corp., a New York consulting firm. But “everybody is sort of being pushed to do this, [so] there is no blueprint about how this is going to work.”

The NASD board approved a second daily trading session from 2:30 p.m. to either 6 p.m. or 7 p.m. Pacific time. Regular hours are 6:30 a.m. to 1 p.m Pacific time. The NASD had originally discussed a July debut, but now won’t specify a start date. Initially, investors can trade Nasdaq’s 100 largest nonfinancial stocks.

The NYSE, whose board will consider late trading at a meeting Thursday, has indicated that it will offer extended trading that roughly matches Nasdaq’s hours and starting date. Both Nasdaq and the NYSE need SEC approval to proceed.

The two major marketplaces are seeking to implement evening trading because they fear losing business to upstart firms that have promised small investors access to evening trading by later this year.

Eclipse Trading Inc. plans after-hours trading from 3 p.m. to 6 p.m. Pacific time, reportedly as early as August. Wit Capital Corp. plans to roll out a system from 4 p.m. to 7 p.m. Pacific time later this year. Instinet Corp., which runs an “electronic communications network,” or ECN, for institutions, will open to individuals by year-end.

Nasdaq and the NYSE have discussed the possibility of cooperating with the ECNs in joint networks, but no formal proposals have been disclosed. Eclipse and Wit have formal regulatory approval to offer after-hours trading.

California investors may initially find the extra sessions of limited benefit because nighttime hours in New York are late afternoon and dinner-time hours on the West Coast. But if late trading succeeds, the firms would probably lengthen their hours.

After-hours investors would likely place orders as they do now, by sending orders to their brokers via computer or telephone.

If Nasdaq and the NYSE are open, brokers may route orders just as they do now. To trade via Eclipse, Wit or Instinet, however, the broker will probably need to sign up in advance with the firms.

For example, Discover Brokerage and Dreyfus Brokerage have signed on with Eclipse. Eclipse announced Tuesday that two Wall Street firms--Discover’s parent, Morgan Stanley Dean Witter, and Salomon Smith Barney--have bought equity stakes in Eclipse.

The central question is whether individual investors can get better executions of their stock trades at night or the next day--and that may be impossible to answer.

Currently, a large portion of discount brokerage firm orders come in after the market has closed. Those orders are queued up and executed in a flurry of activity the next morning. That process, critics say, is far from ideal because small investors don’t know where their orders are in the queue and have no idea of the prices they’ll get.

With evening trading, by contrast, investors would theoretically have their orders filled on the spot.

“The market will be open when they get home from work, and there’ll be more opportunity to get executions when they’re looking at their computer screens,” said Darrin Spencer, OTC trading supervisor at Scottrade.com, a St. Louis-based online brokerage firm.

However, it’s unknown whether enough investors will be drawn to after-hours markets. Without a sufficient number of orders to provide liquidity, small investors may have trouble buying and selling stocks at their desired time and price. That could cause extreme volatility in stock prices.

“You could end up with people getting some pretty awful executions,” said one NASD board member, who asked not to be identified.

And even with sufficient liquidity, some experts worry that fragmentation would occur because no single trading system would have enough order flow. In other words, an investor trying to buy 100 shares of XYZ through Eclipse may not be able to find someone selling 100 shares on Wit.

“There is a real question of fragmentation of markets,” Noser said. “It’s best for liquidity if the markets are centralized [and] everybody’s coming to the same place to trade.”

In any case, investors should always use limit orders when trading after-hours to guard against order executions that are drastically different from the prices they expect.

Limit orders specify a price at which an investor will buy or sell a stock. If the order is filled, the customer is guaranteed that price or better. That compares with market orders, which are open-ended and can vary according to the price at the moment the order is filled.

“To just go in at the ‘market’ could be bad during the day, but terrible at night,” one NASD board member said.

Another issue is that the gap between each stock’s “bid” and “ask” price could be very wide. The bid is the lower price at which Wall Street firms buy stock from small investors. The ask is the higher price at which they sell. The “spread” between the two prices is the firm’s profit on each trade.

The thinner the spread, the less risky the trade for an individual investor. The logic is this: If an investor buys a stock and immediately sells it, he would lose less money with a smaller spread.

For example, if an investor bought 500 shares of a stock with a 13-cent spread, he or she would lose $65 by selling immediately. If the spread were 50 cents, it would cost the investor $250.

The irony may be that after-hours trading may not put individuals on par with institutions when it comes to reacting to company announcements after the close.

On Nasdaq, there would be a 90-minute period between the end of the first session and beginning of the second when individuals couldn’t trade. But because institutions would be able to keep trading through Instinet, they would still hold an advantage.

Proponents of after-hours trading think the worries are excessive.

Edward Wedbush, president and chief executive of Wedbush Morgan Securities, a Los Angeles-based investment banking and brokerage firm, thinks individuals drawn to after-hours trading will be the most savvy and least at risk.

“They see the bid and the offer and they know what it’s like to put in a ‘market’ order,” Wedbush said. “I think it’s no more dangerous than trading during the day.”

If evening trading catches on, some of the potential dangers may fix themselves, experts say. Ample order flow could beget even more order flow, thus compressing spreads and reducing price fluctuations.

“It’s a chicken-and-egg thing,” Wedbush said. “If there’s business, the more attractive it’ll be for more business.”

Added Spencer: “It’s something that’s going to happen, and something customers do want in general.”

As long as the bull market keeps its stride, many others agree. However, a bear market might be a different story.

“I think [after-hours trading] is a creature of the bull market,” Noser said. “And if we get into a bad market, it’s going to evaporate.”

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Times staff writer Walter Hamilton discusses the day’s market action regularly on the KFWB-Los Angeles Times Noon Business Hour. He can be reached at walter.hamilton@latimes.com.