I Get Paid to Take Risk

Reading over my post from earlier this week, I feel I did not do a good enough job of explaining what I meant by an overnight “risk premium” so I’m going to give it another shot.

First some background, as a trader, I don’t trade equities, I don’t trade futures, I don’t trade options and I don’t trade bonds, I trade risk. Whenever I enter a trade, I am assuming the “risk” of the instrument until the time I end the trade. All the instruments I mentioned are just different vehicles for risk with different parameters.

For example, suppose I am day trader who specializes in trading AAPL stock. Whenever I enter a trade intraday, I am assuming the risk of that many AAPL shares for as long as I control them. Suppose I have a 500 share position in AAPL @ $80 for a total position value of $40,000. What type of risk have I assumed? Normally, AAPL has been moving between $2-$3 on average per day which is what we could assume on a “normal” day, but since we’re talking about risk we can’t always assume a “normal” day. Lets consider these two scenarios:

1. 2 minutes after you enter your position, CNN announces that there has been a tragic private plane crash and Steve Jobs, along with other members of Apple’s senior management are believed to have perished on their way to an meeting in the Caribbean. What is your risk now?

2. 2 minutes after you enter your position CNN announces that President Bush has decided as part of his revised “No Child Left Behind” act, he has decided that all US School Children will be provided with a new Apple iPod upon entering the 9th grade loaded with educational and classic audio books. What is your risk now?

Obviously those are two extreme cases of what could be expected intraday, and your risk would depend on if you were long or short. Because whenever your are involved in an individual equity, you are taking the risk that the general perception of that equity will not change significantly while you are involved. In the case of a liquid stock like AAPL, even a worst case scenario would still provide plenty of buyers, just at a reduced price, but in smaller, illiquid investments, a change in perception can lead to cases where there are not any buyers at all.

Now suppose you are a swing trader and are holding 500 shares of AAPL for multiple days at a time. Besides the above scenarios you may also encounter these:

3. After hours, Apple announces that the European union has found iTunes in violation of their copyright laws and has granted an injunction against all iPods in Europe. What is your risk now?

4. After hours, MSFT has decided that the Zune is a failure and has offered to buy AAPL for $150 per shares. What is your risk now?

5. After hours, Apple warns that the iPod appears to be reaching saturation and growth is slowing. What is your risk now?

6. After hours, Apple announces that iPod growth is running 2x above the most optimistic expectations. What is your risk now?

7. Just after midnight New York time, the US announces that a series of major airstrikes are in progress against Iran due to their refusal to turn over the captured British soldiers.

I’m sure you can think of at least 50 other scenarios of major news that could move AAPL afterhours and that is my point. The potential for large, share moving news is obviously higher after hours then during trading hours for 2 reasons. First, the system is setup so that all large company news events (earnings, warnings, takeovers, etc) are announced after trading hours. Second, the market is closed far more then it is open per week, thus making it more likely that geopolitical shifts will occur outside of market hours.

It is exactly this risk that I was attempting to measure in my previous post. How much more will the market pay you for holding AAPL overnight versus intraday.

Lets find out.  Since AAPL went public in 1984, if you’d bought a single share of APPL each night and sold it the next morning, you would have netted (not including slippage and commissions), 120.54 points.  If you’d bought each open and sold each close you would have netted (not including slippage and commissions) -30.83.

Think about that, Apple has been public for 23 years, and the total risk premium paid to overnight holders is ~30% more then the current share price, while the risk premium paid for the entire intraday session is negative.

Also, one of my readers asked how the test I ran comparing holding overnight to holding intraday on the Nasdaq 100 would have performed in a bear market.   Here are the results from 3/1/2000-3/1/2003.  Same settings as before, $10,000 per position using current Nasdaq 100

Overnight:

DayTrading:

For reference, buy and hold was about -$100,000 total.  As you can see, the difference in the risk premium between overnight and intraday is even larger in times of higher volatility and uncertainty as the period of 3/2000 - 3/2003 shows.  It was amazing to me that the overnight script was able to be profitable.

- John