Takeaways
- Finance researchers have long wondered why some stocks seem to gain value overnight. The increase in stock price from market close to its opening price the next day is referred to as the difference between overnight and intraday returns.
- Demand is generated by nimble retail traders rushing to buy the stock when markets first open. Stock prices spike because there aren’t enough large brokerages ready and willing to sell the in-demand stock based on limited information early in the day.
- Once managers at the larger trading houses understand whether the retail traders are acting on real information or rumors, they start selling their shares — raising the inventory and reducing the price.
On any given day when the bell opens trading at the New York Stock Exchange, some stocks mysteriously have appreciated overnight.
The phenomenon has long puzzled researchers, but University of Georgia finance professors recently uncovered its main driver — the difference in the risk faced by large traditional brokerages and quick-trading upstart firms.
Zhongjin Lu and Steven Malliaris, both assistant professors of finance in the Terry College of Business, and their coauthor Zhongling Qin — a former Terry doctoral student and faculty member at Auburn University — published their findings this spring in the Journal of Financial Economics.
“It was a puzzle,” Lu said. “This pattern has existed for four decades, and the pattern still exists. Market makers know this, so the question was: Why don’t the large market makers come in earlier to meet the morning demand for stocks, benefit from the higher prices and drive the prices down?”
The difference in stock price at market close and its opening price the next day is referred to as the difference between overnight and intraday returns. The phenomenon occurs in large managed funds, such as ETFs, but also in individual stocks.
Lu started studying it in 2020 when a spike in retail stock trading was making headlines in the financial press. A common circulating assumption was the influx of retail traders fueled the difference between intraday returns.
“There was a view this was completely driven by trading demand such as retail trading, but that wasn’t consistent with what we found in the data,” Lu said.
The stocks that peak in value at the start of trading day and lose value later in the day were among the more volatile stocks in the market. These are also the stocks most retail day traders prefer since they offer the chance for big, quick returns, Lu said. The prevailing hypothesis was that early morning demand drove up prices, which corrected during the day.
“A popular view was that you have a retail trader sitting there in the evening and reading the evening news, and he sees some exciting news,” Lu said. “The next morning, he and other retail traders rush to buy the stock and the price spikes.”
According to this theory, demand for the stock ebbs during the day as the excitement that caused retail buyers to act subsides.
But when Lu, Malliaris and Qin analyzed the record of all stock trades for 22 years, they found the demand for the volatile stocks didn’t ebb throughout the day. What did change, Malliaris said, was the willingness of brokerage houses and other large market makers to offer shares of the in-demand stock.
Smaller high-frequency trading houses — deploying between hundreds of millions to a few billion dollars capital — and larger brokerage houses and asset management firms— often managing hundreds of billions in assets — have different strategies for managing stock trades and assets, Lu explained. Small high-frequency trading companies maximize profits by trading quickly; larger trading firms make more money by taking larger positions.
When markets first open, the first market brokers willing to sell shares of high-demand stocks are smaller high-frequency trading houses. They have fewer assets and can accommodate fewer buyers. Their relatively low stock inventory keeps the supply of the in-demand stock low and prices higher. The larger brokerage houses and asset management firms, which have more capacity and access to stock shares, don’t offer their supply of in-demand stock until later in the morning.
When they start selling their supply of in-demand stock, supply is plentiful, and prices drop.
What’s puzzling, Malliaris said, is why larger market makers forgo the premium they would get from selling to those first highly motivated buyers.
“These are incredibly sophisticated people who are in this market all the time,” he said “If anybody is going to understand that this sale price is going to go down throughout the day, it’s them. So, if they’re willing to provide liquidity by filling these trades later in the day, then what is stopping them from providing that same liquidity earlier in the day and competing away this pattern.”
The answer is they’re waiting for smaller, more nimble trading houses to discern whether the eager traders are acting on actual information or just a random hunch.
If larger market makers meet the demand for these stocks early in the morning, they risk losing value over the day if the stock value increases. If demand for the stock isn’t based on material information, they can still take advantage of the elevated demand from retail traders during the day after better understanding what is happening, Malliaris said.
These large market makers don’t need to chase the small amount they would make from meeting elevated demand when markets open, Lu added.
“Throughout the morning, there is lots of trading, and that trading reveals information,” Lu continued. “These are sophisticated investors at the big trading houses, and they are watching how the price moves and combining that with the news that first fueled the demand for the stock.”
That information gives the larger house more confidence to open its stock supply to the market and adjust its prices accordingly.
“That entire reversal only takes about 30 minutes to complete,” Lu added.
More than simply explaining a curiosity about market behavior, Lu and Malliaris’s work uncovers the mechanics of how new information integrates into the market and how the interaction of smaller high-frequency trading companies and larger trading firms affect the price of stocks.
