Market researchers are exploring whether stocks perform better at night than during normal trading hours. The 'overnight effect' anomaly is an emerging concept that involves buying US equities at market close and selling them at open to potentially generate more profits.
For instance, the S&P 500 index (SPX) climbed 6.6% in the past year through 15th April. However, if you invested in an exchange-traded fund (ETF) tracking the index during overnight hours, the portfolio would have returned 6.8%. Data suggests that over 100% of the market gains in the past year were recorded when the stock exchanges were closed. Meanwhile, the total returns of a portfolio that bought and sold in the S&P 500 exclusively during regular trading hours would have witnessed negative returns.
Advisory firm Elm Street found in a study that over the three decades ending 2022, investors earned 100% or higher of the [market's buy-and-hold] return during after-hours sessions compared with zero or negative returns for those who invested when markets were open. Keep in mind that these estimates don't consider transaction costs.
How to Apply the Overnight Trading Strategy?
Leveraging the overnight effect would mean buying into an ETF like the SPDR S&P 500 SPY when the market closes at 4:00 p.m. ET every session and selling the holdings at 9:30 a.m. ET the next trading day.
Although this strategy could mean hundreds of trades annually and incur transactional charges, estimates suggest that the overheads would cost the overnight portfolio roughly one percentage point.
It is important to note that short-term trades will also subject your gains to the higher short-term capital gains tax rate. So, you can avoid these implications by using the overnight effect strategy in a tax-deferred account.
Note that investors shouldn't solely attempt to profit from market patterns, especially during a volatile macro backdrop.
Overnight effect can be Traced to the Earnings Season
University of California's Terry Marsh and Kam Fong Chan of the University of Western Australia found in their recent study entitled 'Overnight Post-Earnings Announcement Drift and SEC Form 8-K Disclosures' that the overnight effect is more prominent during earnings seasons because most companies report their quarterly results after market close.
The extreme market reaction to surprise earnings can be understood with a simple example. The Travelers Companies (NYSE:TRV) recently reported its Q1 earnings in the early hours of 16th April, beating consensus earnings per share estimates to post an impressive £1.44 ($1.91). When the markets opened after several hours, the stock was 2.5% higher compared with the previous day's close. However, the stock declined by 1.3% over the regular session from the day's peak.
While not all earnings releases are positive, most are. Furthermore, a surprise positive will have a relatively small impact on the S&P 500. For our example of Travelers Companies, the stock has a 0.13% weighting in the benchmark index. Hence, the overnight trading strategy could also mean small accumulations of surprises like company results and subsequent stock movements over the long term.
Overall, this strategy has historically performed better than trading during regular sessions but requires patience and the timing to enter and exit the market at specified times.
Disclaimer: Our digital media content is for informational purposes only and not investment advice. Please conduct your own analysis or seek professional advice before investing. Remember, investments are subject to market risks and past performance doesn't indicate future returns.
