Academic journal article Financial Management

The Timing of Opening Trades and Pricing Errors

Academic journal article Financial Management

The Timing of Opening Trades and Pricing Errors

Article excerpt

After demonstrating that a zero investment trading strategy that buys stocks with overnight returns below the market average and sells stocks with overnight returns above the market average earns more than 1% monthly profit, I demonstrate that this profit is greater for stocks that start trading more quickly than for other stocks. These results control for trading costs. The resulting pricing errors are a material portion of stock price volatility and suggest that a quick response to overnight information adds non-information-based stock volatility to stock prices.

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Opening prices are known to be more volatile than closing prices after controlling for the amount of information arrivals (Amihud and Mendelson, 1987; Stoll and Whaley, 1990; Stoll, 2000). This suggests a certain degree of inefficiency in opening prices which is yet to be fully understood. I consider the possibility that this behavior may be related to traders overacting to overnight information. In particular, traders who trade very quickly after the markets open are driving prices away from fundamental values by not waiting to fully incorporate all available information.

The speed of the reaction to information is often regarded as an indicator of stock market efficiency. If stock prices react slowly to information, there is an opportunity to profit from public information, thus violating semi-strong form market efficiency, (1) However, it is equally inefficient if the rapid reactions are not accurate reflections of the information given. French and Roll (1986) and Kim and Verrechia (1994) note that stock price volatility increases when investors cannot accurately estimate the true value of information. According Chan (1993), the estimation is more difficult when stocks react faster than others as investors update their estimates of value by learning from the price reactions of similar stocks. (2) With limited price data from other firms to consult, investors may incorrectly estimate the true value of the stock.

Although this idea may be an important challenge to the trend equating the speed of reaction and market efficiency, there has been little supporting empirical evidence regarding the relationship between pricing error and the speed of reaction. I explore this question by examining opening trades from September 1997 to January 2001 when the NASDAQ had a continuous trading structure at the market open instead of the opening call auction process that has been used for other trading periods. Within this period, I can observe the exact sequence of opening trades after a long period of non-trading hours in which overnight information had been accumulated. I use data from this period to examine how accurately investors interpret overnight information and how the time of the opening trade of a stock is related to its pricing error.

I find two notable patterns in the NASDAQ opening prices. First, opening prices exhibit economically significant pricing errors. The pricing errors are estimated using a simple strategy of buying stocks whose overnight return (close to opening trade) is lower than the equal-weighted market return and selling stocks whose overnight return is higher than the market return. This strategy enables me to estimate the amount of mean reversion of a stock opening price after controlling for the overall market movement. I find that this strategy yields more than 1% return per month, after controlling for bid-ask spread and scarce trading issues. More importantly, the stocks that traded sooner after the market opening exhibit greater mean reversion. The difference in mean reversion between the fastest reaction groups and the slowest reaction groups is 0.54% per day. I find that the significant correlation between market-adjusted mean reversion and the speed of opening exists even after controlling for standard liquidity variables such as firm size, bid-ask spread, and volume. This pattern indicates that earlier opening increases significant errors in stock prices. …

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