By Phil Mackintosh, Chief Economist, Nasdaq
Retail are early risers
Given how retail trades, we can estimate what times retail investors trade by looking at sub-decimal prints on the tape (SIP). To see why looking at sub-decimal trades helps capture mostly retail trades, read our prior studies here and here.
In addition to wholesalers, some exchanges have approved retail programs that let them execute at sub-decimal prices too. Anyone is allowed to provide liquidity into these programs, but only retail is allowed to take from those posted, price-improving quotes.
When we aggregate the data for a month into 15-minute time buckets across the day, what we see is that retail trades differently than the broader market because they do much more of their trading in the morning and almost none in the close (Chart 1).
It’s also important to note that many exchanges are open for trading from 4 a.m. until 8 p.m., even though official “market hours” are 9:30 a.m. to 4 p.m. That allows investors to still match trades after hours, which often occurs when a stock issues earnings or other news late, or alongside economic news that is often released in the morning.
Finally, the data in Chart 1 (green line) shows off-exchange retail spikes at 8 a.m. However, that’s because the TRF starts at 8 a.m., so all the off-exchange trades done in the prior 12 hours are printed to the tape in a group at 8 a.m. Exchange retail programs also need market makers to be active, so they also tend to start later. For example, the Nasdaq BX RPI program starts at 8 a.m.
Chart 1: Retail VWAP curves show more trading in the morning
Institutions trade more later
In contrast, the rest of the market does a significant proportion of their daily trading volume nearer to and in the close. In fact, from 3:45 p.m. until close, we see around 14.1% of all volume traded, even though it is less than 4% of the trading day.
That’s partly because index providers compute benchmark performance daily, using close prices. Those prices are used to measure professional investors’ portfolio performance, as well as computing unit prices for mutual fund cashflows.
That means close matters for portfolio performance. So even stock-picking mutual funds sometimes need to invest as close to close prices as possible, especially with large cashflows. Index funds, which have the least tolerance for missing their benchmark, execute even more of their trades in the close auction. In fact, doing all trading in the close will match trades and cashflows perfectly to index change prices, eliminating the risk that trade timing causes underperformance and tracking error in the fund.
However, as we’ve previously shown, it’s not just index funds trading in the close. Data suggests index funds usually make up just a fraction of each day’s close.
Exchange programs perform better outside of continuous trading
The data also shows that retail does trade outside of “market hours,” although not that much. In fact, the total pre- and post-market trading account for just 3.6% of their overall volume traded.
Looking at sub-decimal SIP trades on the TRF and exchanges retail programs separately, we see that retail investors prefer exchange retail programs very early in the morning. However, once the official trading day has started and a protected NBBO is available to compute EQ metrics, wholesalers quickly gain market share.
Outside of normal market hours, spreads are much wider
Enticing market makers to make competitive quotes is an important function of exchanges.
Not only is trading activity concentrated during official market hours, but we also see that quoting is much more competitive during that time. In fact, data shows that spreads widen considerably outside official market hours.
On a value-weighted basis, quotes outside of market hours are more than 10-times wider. However, that’s partly because a lot of market-moving news arrives outside market hours. Most earnings are released after the close, and when that happens, those tickers trade the most value with a lot of price discovery – leading to wider spreads – skewing this result. A lot of important U.S. economic data is also released before markets open, also adding to market maker risks, given the lower liquidity available to hedge. And of course, market-moving international news also often occurs while U.S. markets are closed.
For a retail investor, this makes it much more important to use limit orders based around what prices you think are fair given the news available.
Chart 2: Spreads compress significantly during official market hours
Source: Nasdaq Economic Research
What does this all mean?
In short: Compared to other investors, retail trades early, even before the markets open.
The data also shows that outside market hours, when trade-through and execution quality (605) rules aren’t in effect, having a competitive quote on an exchange is also important. Interestingly, during regular market hours, when spreads are tighter, activity seems to shift to wholesalers.
This also seems to show both the importance of competitive quotes and the fact that retail brokers modify routing over the day to ensure they get the best prices possible for their customers.