This article is by Gabriel Kan, Kei Gamo & Tom Kingsley.
Global economic slowdown, monetary policies and political unrest have introduced significant uncertainty to the equity market. The risk of holding a U.S. equity position overnight, measured by the difference between previous day’s closing price and market opening price, has increased by more than seven times in the last four years from 2.3bp in 2012 to 17.5bp in 2016 H1. The overnight gap risk is trending towards the 2008 financial crisis level at 28.1bp.
The higher degree of interconnectivity and information flow among global equity markets contributes to the increase in the overnight gap risk. In particular, information revealed in the Asia equity markets appears to have a significant impact on the U.S. market open. For example, the intraday return of Nikkei-225 index (day open to day close) exhibits a high correlation to the overnight return of S&P 500 index (previous close to day open) at 43% in 2016 H1. The current inter-market correlation is the highest since the 2008 financial crisis, and has doubled in the last two years.
For a strategic trader, the gap risk in the U.S. equity market represents opportunity to profit from the information revealed in Asia. The signal from Asia appears to be even stronger if the intraday move is larger. If Nikkei-225 index changes by more than 1% from open to close, its correlation to the S&P 500 index increases to 56%, compared to only a 25% increase if its intraday change is smaller than 1%. On the other hand, the ability to unload the risk during Asia hours becomes critical for a risk-averse trader. When important corporate or government events are going to happen, risk-averse traders could protect themselves from the price swing by off-loading their positions early. When the two types of traders meet, a potential matching of orders happens.
There are two advantages for this type of matching. First, the matching would likely happen during Asia hours when information is revealed. This provides risk-averse traders the ability to hedge before U.S. market open, at the same time, and allows strategic traders to anticipate the gap direction. Second, the matching price is likely to be the previous day closing price. While the closing price is commonly used as the valuation benchmark, this would provide the maximum hedge for risk-averse traders as well as the maximum gap exposure for strategic traders. The matching results from Bloomberg Tradebook’s IWUD<GO> matching platform confirm this phenomenon.
As an independent equity crossing platform, IWUD<GO> allows traders to show their interest of matching U.S. equity during Asia hours. Quantity and price are negotiable between buyers and sellers. From the U.S. equity matches in 2016 H1, 96% of them were completed at the previous closing price. On average, IWUD<GO> matches offset 90bp of gap risk, measured by the matching price vs. the next day opening price, which represents 15 times the average bid-ask spread of the underlying stocks at 6bp. This illustrates the value of an off-hours off-exchange crossing network.