After-Hours Spreads - Why Are They Getting Wider?
Transaction costs are one of the most important variables to take into account when trading. While commissions and other fees can be analysed ahead of time, the most common cost, the bid-ask spread, is highly variable and dependent on market liquidity. There are a number of internal and external forces that influence liquidity, with spreads often rising during news announcements and other volatile periods. However, spreads can also rise during the quiet hours, with 'out of market' spreads typically wider then those available during normal market hours.
Regardless of the financial instrument in question, the spread is a direct relationship between the bid and ask prices of a particular security at a defined time. The bid price is the amount a buyer is prepared to pay for a security, and the ask price is the amount the seller is asking in return. This may seem like a simple enough transaction at first glance, until you realise that the difference between the bid and ask price is often highly variable. While the spread can be fixed under certain conditions, variable spreads are common and often misunderstood.
It's a well recognised fact that spreads widen during highly volatile market conditions. Some obvious examples include market open times, market close times, and news announcements. Volatility usually increases during times of rapid price decline or advancement, when the difference between the bid and ask price becomes larger. While the opposite is normally the case and periods of low volatility are generally accompanied by tightening spreads, there are some important exceptions that needs to be taken into account.
While spreads widen all the time because of volatility, they will also widen due to lack of liquidity. Under normal market conditions this is not a problem, as brokers are able to quote spreads that directly represent the current price of the market in question. However, lack of liquidity becomes an issue during off-market hours, with brokers requiring more compensation for handling a transaction due to their inability to accurately reflect current price conditions. This combination of unknown factors and low trading volume results in wider spreads.
In effect, the space between one day and the next or one week and the next represents an unknown lag in price, where even brokers have to deal with price like its a quantum cloud of possibilities rather than an accurate point on a chart. While some brokers are able to make up prices based on what correlated markets are doing, this level of uncertainty comes at a cost to traders. Along with wider spreads, stop-loss and entry orders may be triggered when they would not have during in-hours trading and maximum trade sizes may be reduced.
Because some firms only allow investors to view quotes from a single trading system, traders may not even be able to see or act upon quotes after-hours. While it may be possible to access quotes on other ECNs after-hours, it's important to check with your broker if you want to route an execution order to another ECN. If you are limited to the quotes available within one system, it may not even be possible to complete a trade after-hours, even with a willing investor using a different trading system.
Different markets are operated and priced differently out-of-hours, with the spot forex market, for example, only closed for one and a half days each week and indices priced from other world indices that are still in hours. However, while different financial instruments will react in unique ways when closed, lack of liquidity is always a factor because trade volume can't be easily converted to cash and price is somewhat unknown by definition in a closed market environment.
While after-hours trading does present investors with new opportunities, there are a number of associated risks. Along with the practical inability to see or act upon quotes, 'out of market' trading will always come with larger spreads due to a lack of liquidity and uncertain prices. Other factors that may also influence the spread after-hours include price volatility from unexpected news, bias towards limit orders, additional competition from professional traders, and computer delays.