Oct 19, 2005:  Over the last couple of years, we've devoted a fair amount of effort checking out various day-trading strategies.  Every approach we've tried has "worked", in the sense of generating theoretical profits...before taxes and commissions and bid/ask spreads are figured in!  Obviously, taxes and commissions and bid/ask spreads are not trivial considerations when day-trading!

Of the myriad strategies our computer has scanned for day-trading possibilities, one stood out...buying stocks that took large losses in the most recent afterhours session.  The tendency for these stocks to rebound from their opening value is hugely significant.  Still, we must say it's questionable whether any profits at all can be realized by buying such stocks at the opening bid and selling them before the close.

Several problems arise when trying to take advantage of these theoretical gains.  Stocks that show large losses in the afterhours can "instantaneously" pop upwards at the open.  In other cases, trading at the open can be furious, with only a few nimble "players" able to reap profits in select cases.  Look at the daily charts of stocks with large afterhours losses, and you'll often see very rapid spikes in price immediately after the open.

We've recently initiated a more "real world" sort of test of the strategy of trying to profit off of afterhours losers.  Here, we sorted our data according to largest afterhours losses and purchased the first stock with a loss no greater than 5% (we didn't want to look at stocks with radical losses in the afterhours), a price no less than $15.00 (since we wish to minimize bid/ask spreads), and a chart that shows, in retrospect, no sudden spikes at the open.  The stocks are purchased at their "ask" value.  Though we've yet to conclude the test, the results have not been particularly promising.  It shouldn't be surprising that the stocks most susceptible to the "afterhours effect" are those that are least tradable.

Whether or not gains can be realized by nimbly entering a position as an opening spike is in progress remains an open question.  Obviously, it's a bit difficult to test this proposition without risking some real money.  In any case, it must be said that such an approach to profits is not for the faint of heart.

We also ran a test that looked at those stocks that showed particularly large rebounds from their afterhours performances.  After identifying a couple of such stocks, we looked at the financial news to see what forces might have driven such turnarounds.  We ran the test on a daily basis for several months.  Not surprisingly, there weren't any hard and fast rules to be found.  Companies sometimes rebounded from a weak earnings report that was released prior to the market open...but sometimes we saw companies lose in the afterhours due to a strong earnings report ("sell on the good news", perhaps), and rebound during regular trading hours.  The hallmark of such rebounds seemed to be some sort of "information gap"...a misperception on the part of traders as to the positivity or negativity of a report.

We've profited from such misperceptions in our own trading experiences.  One real-world scenario has been the following:  a drug company announces that a drug candidate has "failed" a clinical trial.  The immediate result is a sharp downward spike in price before the open.  But knowledgeable investors never gave this drug much of a chance anyway, and the company's future hardly depended on it...so the stock price rebounds as a better picture of "reality" emerges.  The nice thing about these "information gap" situations is that such stocks are usually eminently tradable, because the news creates heavy trading volume and nice liquidity.

It certainly may be possible to realize profits by taking advantage of information gaps.  However, such profits arise only by having a strong understanding of the inner workings of a large number of companies.  It shouldn't be surprising that mechanical formulas for day-trading are elusive, and the traders who do realize profits are likely to be those who are willing to do some serious homework.  For those who are willing to put in the effort, one place to start would be with companies that don't have strong insider or institutional holdings...such stocks would seem particularly vulnerable to momentary misperceptions.

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