Posts Tagged ‘Risks’

23 Jan 2024

Donchian Channels: Formula, Calculations and Uses

Written by admin. Posted in Technical Analysis

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Donchian channels, a popular technical analysis tool, particularly among commodity traders, was developed by Richard Donchian, a pioneer in managed futures. These channels are primarily used to identify breakout points in price moves, which are key for traders looking to capture significant trends.

Key Takeaways

Donchian channels are a popular technical analysis tool, particularly among commodity traders.
The Donchian channel is formed by plotting two boundary lines: the upper line marks the highest security price over a set number of periods, and the lower line marks the lowest price over the same time.
Donchian channels are a versatile tool in technical analysis, offering several practical applications for traders and investors alike.
Combining moving averages, volume indicators, and moving average convergence divergence (MACD) with Donchian channels can lead to a more complete picture of the market for an asset.
Donchian channels can offer clarity for identifying trends and breakout signals. However, their effectiveness hinges on carefully considering period length, market conditions, risk, and match with other indicators.

The Donchian channel is formed by plotting two boundary lines: the upper line marks the highest security price over a set number of periods, and the lower line marks the lowest price over the same periods. The default setting for Donchian channels is 20 periods, the typical number of trading days in a month.

The middle line, frequently included in Donchian channel calculations, represents the average of the upper and lower boundaries. This tool is particularly effective in trending markets, allowing traders to visualize price volatility and momentum. When the price breaks through the upper channel, it may indicate a buying opportunity, signaling a bullish trend. Conversely, a break below the lower channel could be a bearish signal, potentially a prompt to short. However, in range-bound markets, Donchian channels may produce frequent false signals. Thus, this tool is often used with other indicators to confirm trends and filter out noise.

Understanding the Formula and Calculation

Technical analysis in trading evaluates and predicts future price moves and trends for securities. One tool employed is the Donchian channel. While the mathematical formula behind it is straightforward, online trading platforms, charting software, and technical analysis apps can calculate and plot the Donchian channels for you. This convenience is helpful, but it’s also important to understand the nuts and bolts to know the tool’s benefits and limits.

Calculating the Donchian channels involves three basic components: the upper band, the lower band, and the middle band. The middle band is optional. The key aspect of this tool is the period (N), which determines the channel’s sensitivity. A lower value for N makes the channel more sensitive to price moves, while a higher value makes it less sensitive, capturing broader price trends. The selection of N depends on the trader’s strategy, with shorter periods used for shorter-term trading and longer periods for long-term trend following.

The Upper Band

The upper band is calculated by identifying the higher price of the asset over a set number of periods (N).

$Upper Band = max(High over the last N periods)$

The Lower Band

This is the lowest price of the asset over the same number of periods (N).

$Lower Band = min(low over the last N periods)$

The Middle Band

The middle band is the average of the upper and lower bands.

$Middle Band = (Upper Band + Lower Band)/2$

Practical Uses of Donchian Channels

Donchian channels are versatile in technical analysis, with applications that include the following:

Identifying trends: A major use of Donchian channels is to identify the prevailing trend in the market. When the price of an asset consistently trades near the upper band, this indicates a strong uptrend, suggesting bullish sentiment. Conversely, trading near the lower band signals a downtrend, signaling a bearish sentiment.
Breakout signals: They are particularly effective in spotting breakout opportunities. A breakout above the upper band signals a potential buying opportunity since it suggests that the asset might continue to rise. Meanwhile, a break below the lower band can signal a selling or short-selling opportunity since it could suggest the decline has further to go.
Support and resistance levels: The upper and lower bands of the Donchian channel can suggest the support and resistance levels. Traders frequently watch them closely to make buying or selling decisions. For instance, a bounce off the lower band might be seen as a buying opportunity, while resistance at the upper band can be a cue to sell.

Stop loss and exit points: Donchian channels can help set stop loss orders and determine exit points. For example, a common strategy is to place a stop loss order just below the lower band when buying, which helps limit potential losses if the market moves unfavorably.
Measure of volatility: The width of the Donchian channel can serve as an indicator of market volatility. A wider channel indicates higher volatility, as the price is making larger swings over the set period. Conversely, a narrow channel indicates lower volatility.
Filtering noise: In longer-term trading strategies, setting a longer term for the Donchian channels can help filter market noise and help you focus on the relevant price moves.

It should be noted that, like any trading tool in technical analysis, Donchian channels are not foolproof. Traders should know the risk of false breakouts and their limits in sideways markets.

Coordinating Donchian Channels With Other Tools

Donchian channels can be integrated with other technical analysis tools to bolster a trading strategy. Here are several ways to do so:

Moving averages and volume: Moving averages are used to smooth out price data for a period by creating a constantly updated average price. You can lay them over a Donchian channel to confirm or isolate trends. Also, you can use volume charts to confirm the solidity of a breakout signaled by the Donchian channel.

Relative strength index (RSI): This measures how rapid price shifts occur. Often, technical analysts use this data, scored between 0 and 100, to recognize when there’s too much buying or selling of a security. You can use RSI with a Donchian channel to initiate or back off trades. For example, a breakout beyond the upper band, with a high RSI, could suggest an overtraded security and signal the need for caution before buying. Alternatively, a breakout below the lower band and a low RSI could indicate the security is oversold, a signal of a potential buying opportunity.

Moving average convergence divergence (MACD): Using MACD with Donchian channels combines trend and momentum strategies. MACD measures momentum by comparing two moving averages and can be used to confirm signals from a Donchian channel. For example, should a price break the upper Donchian band, signaling a bullish trend, a bullish MACD crossover (when the line in the MACD crosses above the signal line) could indicate how strong the trend is. Likewise, should the price drop beneath the lower Donchian channel and have a bearish MACD crossover, this would signal that the move downward is a strong trend.

Factors to Consider When Using Donchian Channels

When using Donchian channels, several factors should be tailored to individual trading strategies:

Selecting the period length: The default setting is 20 periods, but traders may adjust it to suit their trading needs and style. A shorter period makes the channel more sensitive to recent price moves, which is ideal for short-term trading. In contrast, a longer period smooths out the price data, which can be beneficial for long-term trend following.
Market conditions: Donchian channels are most effective in trending markets. In range-bound or sideways markets, the channels may produce frequent false signals. It is essential to assess the overall market condition and use Donchian channels accordingly, possibly with other indicators that help identify market phases.
Risk management: As with any trading strategy, risk management is crucial. Setting stop-loss orders is recommended to manage potential losses, especially in volatile markets. A stop loss at the lower and upper bands of the Donchian channel can be strategically placed for a long position and a short position, respectively.
Combining with other indicators: To help confirm signals and reduce the risk of false breakouts, it is often beneficial to use Donchian channels with other technical indicators like the relative strength index (RSI), the moving average convergence divergence (MACD), or moving averages. This multiple-indicator approach can provide a more complete view of the market.

Understanding false breakouts: A challenge with Donchian channels is that false breakouts occur when the price breaks through a band but then quickly reverses. Being ready for potential false signals is necessary for effective trading.
Historical performance: Analyzing how an asset has historically responded to Donchian channel levels can help understand how it might perform in the future. However, past performance does not always indicate future results, so this should be one of several considerations.
Adjustments for different assets: Different assets may behave differently, and what works for one asset or market may not work for another. Adjusting the settings of the Donchian channels to suit the characteristics of the specific assets is often necessary.
Volatility consideration: The Donchian channel’s width can indicate the asset’s volatility. The channels will widen in highly volatile markets, and the price might hit the bands more frequently. This should be taken into account when interpreting the signals generated.

Backtesting: Before applying Donchian channels strategies to live trading, backtesting on historical data may prove beneficial. This helps in understanding how the strategy would have performed in the past and in refining the approach based on real market data.
Market context: Economic indicators, market sentiment, and fundamental factors should not be ignored. The overall market context needs to be considered. Tools like Donchian channels are most effective in a comprehensive trading strategy considering diverse market aspects.

Limitations and Risks of Donchian Channels

Donchian channels, like any technical analysis tool, have certain limitations and risks that traders should know:

Lagging indicator: The first limitation concerns lag. Donchian channels are based on past price data, making them lagging indicators. This means they react to price changes rather than predict them. In rapidly changing markets, this lag can lead to delayed entry and exit signals, potentially impacting the profitability of trades.

False breakouts: A significant risk associated with Donchian channels is the occurrence of false breakouts. The price may break through the upper or lower band, suggesting a trend change or continuation, but then quickly reverse direction. This can lead to traders entering or exiting positions based on misleading signals.

Sideways markets: Donchian channels are most effective in trending markets. In range-bound or sideways markets, when the price fluctuates within a narrow band, these channels can produce frequent whipsaws, frequent reversals leading to confusion and potential losses.

Overreliance on them: Moreover, relying solely on Donchian channels for trading decisions can be risky. It is generally more effective to use with other technical analysis tools and fundamental analysis to confirm signals and gain a more comprehensive market perspective. Indeed, while Donchian channels can help set stop-loss levels, determining the best place for these stops can be challenging, especially in volatile markets. The wrong stop-loss settings can lead to premature exits from potentially profitable trades or substantial losses.

The wrong period setting: The effectiveness of Donchian channels is also heavily dependent on the chosen period setting. Different settings can produce vastly different results, and no one-size-fits-all setting works for all markets or all types of assets. In addition, traders might experience psychological biases, such as confirmation bias, when they only use the channel signals that confirm their preexisting beliefs or positions. This can lead to misguided trading decisions.

Leaves a lot out: It should be noted that Donchian channels do not consider broader market conditions, news events, economic data releases, or other fundamental factors that can significantly impact asset prices. The tool ignores market context. Finally, traders might unintentionally introduce bias by selecting channel parameters that align with their desired outcomes rather than those that objectively reflect market conditions.

Understanding these limitations and risks is required for effectively using Donchian channels in trading. Traders are typically advised to use a holistic approach that combines several methods of analysis methods and sound risk management practices.

Example of Donchian Channel Trading Strategy

This example entails using the Donchian channel on the exchange-traded fund Invesco QQQ Trust Series (QQQ). This example was conducted on a four-hour chart from Dec. 14, 2022, to Dec. 14, 2023.

The buy condition occurs when the candle’s high is above the Donchian channel’s upper band. This would close any short positions. Conversely, the sell condition rule entails when the candle’s low is lower than the lower band of the Donchian channel. This condition will close any long positions.

The strategy assumptions for Donchian channel trading include the following:

Initial capital of $1,000,000
Order size of 100% of equity
No pyramiding of orders
No leveraged trades
Commissions and slippage are ignored
Period length of 20

Donchian Channel on QQQ.

Tradingview

The results are as follows:

Net profit: 9.64%
Total closed trades: 15
Percentage of profitable trades: 46.67%
Profit factor generated: 1.35
Maximum drawdown: 14.87%
Buy and hold over same period: 55.12%

Donchian Channel Profit and Loss.

Tradingview

This example illustrates the potential effectiveness of the Donchian channels. However, it is critical to note that traders typically utilize more complex trading strategies and leverage, and they subject the indicator to more extensive backtesting and optimization before applying it to real trading.

Other Indicators Similar to Donchian Channels

Several technical analysis indicators share similarities with Donchian channels:

Bollinger Bands: A volatility indicator consisting of a middle simple moving average and two standard deviation lines above and below it.
Keltner channels: Like Bollinger Bands, but the channels are defined by an exponential moving average and average true range.
Moving average envelopes: These are moving averages set above and below the price by a specified percentage.
Price channels: Plots a security’s highest high and lowest low over a certain period.
Average true range bands: Creates a volatility-based range around the price based on the average true range of an asset.

How Reliable are Donchian Channels?

The reliability of Donchian channels, like any technical analysis tool, depends on several factors. Its effectiveness can vary based on market conditions, asset types, and how it is used within a broader trading strategy. Donchian channels should be employed with an understanding of their limitations and with other analysis methods and sound trading practices.

How do Donchian Channels Differ From Other Technical Analysis Indicators?

Donchian channels differ from other technical analysis indicators in several key ways. One is their focus on price extremes while exhibiting strong trend lines. Many technical analysis indicators give a smoothed average price trend, while Donchian channels create a band enclosing the extreme highs and lows. This can be particularly useful for identifying breakout points and the size of volatility.

How Do I Pick the Number of Periods for a Donchian Channel?

Selecting the right number of periods for Donchian channels is crucial and should match your trading strategy, your trading horizon, and the market’s volatility. Fewer periods will be more responsive to price moves, which is better for short-term trading. A higher number of periods gives you a wider overview of market trends, which is better for long-term trading strategies. You should also consider the asset or market involved, the range in price for the market or asset over time, and your risk tolerance when setting the number of periods.

What are the Best Technical Analysis Indicators to use with Donchian Channels?

Combining Donchian channels with other technical analysis indicators can create a more robust and comprehensive trading strategy. The best indicators to pair with Donchian channels typically complement their trend-following nature or help in confirming signals. Some indicators include the RSI, MACD, the average directional index, the stochastic oscillator, the parabolic stop and reverse, and candlestick patterns.

The Bottom Line

Donchian channels, a technical analysis tool developed by Richard Donchian, can effectively identify market trends and potential breakout points. The channels are constructed using two primary lines: the upper band, which is the highest price over a set number of periods (typically 20), and the lower band, which is the lowest price over the same number of periods. An optional middle band can also be included, representing the average of the upper and lower bands. The simplicity of this formula, focusing on price extremes, enables traders to visualize market volatility, momentum, and potential shifts in market trends.

Donchian channels are versatile and can be adapted to diverse trading strategies and time frames, from day trading to long-term investing. They are commonly used to spot breakout prospects, with a break above the upper channel indicating a potential buy signal and a break below the lower channel suggesting a sell or short sell signal. However, they are most effective in trending markets and can produce false signals in range-bound scenarios. Hence, they are usually used with other indicators, like RSI or MACD, for a more comprehensive analysis. While Donchian channels offer valuable insights, traders should be aware of their limitations and incorporate them into a broader, diversified trading strategy that aligns with their risk tolerance and market outlook.

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27 Nov 2008

All Risk Insurance: What Is All Risk Insurance, and What Does It (and Doesn’t) Cover?

Written by admin. Posted in A, Financial Terms Dictionary

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What Is All Risks?

“All risks” refers to a type of insurance coverage that automatically covers any risk that the contract does not explicitly omit. For example, if an “all risk” homeowner’s policy does not expressly exclude flood coverage, then the house will be covered in the event of flood damage.

This type of policy is found only in the property-casualty market.

Key Takeaways

All risks is a comprehensive insurance policy offered in the property-casualty market.
All risks and named perils are two types of insurance commonly offered to homeowners and business owners.
Insurance that allows for all risks means the policyholder can seek compensation for any events that the contract hasn’t directly ruled out as being covered.
Policyholders can usually pay more to have a rider or floater added to the contract that would cover a specific event that was ruled out.
All risks insurance differs from named perils insurance, in which the policyholder can only seek compensation for events that are specified in the policy.

Understanding All Risks

Insurance providers generally offer two types of property coverage for homeowners and businesses—named perils and “all risks.” A named perils insurance contract only covers the perils stipulated explicitly in the policy.

For example, an insurance contract might specify that any home loss caused by fire or vandalism will be covered. Therefore, an insured who experiences a loss or damage caused by a flood cannot file a claim to his or her insurance provider, as a flood is not named as a peril under the insurance coverage. Under a named perils policy, the burden of proof is on the insured.

An all risks insurance contract covers the insured from all perils, except the ones specifically excluded from the list. Contrary to a named perils contract, an all risks policy does not name the risks covered, but instead, names the risks not covered. In so doing, any peril not named in the exclusions list is automatically covered.

The most common types of perils excluded from “all risks” include earthquake, war, government seizure or destruction, wear and tear, infestation, pollution, nuclear hazard, and market loss. An individual or business who requires coverage for any excluded event under “all risks” may have the option to pay an additional premium, known as a rider or floater, to have the peril included in the contract.

“All risks” are also called open perils, all perils, or comprehensive insurance.

Burden of Proof

The trigger for coverage under an “all risks” policy is physical loss or damage to property. An insured must prove physical damage or loss has occurred before the burden of proof shifts to the insurer, who then has to prove that an exclusion applies to the coverage.

For example, a small business that experienced a power outage may file a claim citing physical loss. The insurance company, on the other hand, might reject the claim stating that the company experienced a loss of income from a mere loss of property use, which is not the same thing as a physical loss of property.

Special Considerations

Because “all risks” is the most comprehensive type of coverage available and protects the insured from a greater number of possible loss events, it is priced proportionately higher than other types of policies. The cost of this type of insurance should, therefore, be measured against the probability of a claim.

It is possible to have named perils and “all risks” in the same policy. For example, an insured may have a property insurance policy that has all risks coverage on the building and named perils on his personal property. Everyone should read the fine print of any insurance agreement to ensure that they understand what is excluded in the policy.

Also, just because an insurance policy is termed “all risks” does not mean that it covers “all risks” since the exclusions reduce the level of coverage that is offered. Make sure you look for the exclusions in any prospective policy.

What Is the Meaning of All Risk?

All risk is a type of insurance product that requires a risk to be explicitly stated for it to not be covered. For example, if the contract does not state “tree damage” as an omitting risk, then if a tree were to fall on the insured property under an all risk policy, since the tree was not explicitly mentioned, the damage would be covered.

What Are the 4 Major Types of Insurance?

There are insurance products for almost everything, but for most people, there are four types of insurance products that are seen more than any other. Life insurance, auto insurance, health insurance, and long-term disability insurance are those that cover most of an individual’s risk factors. Once someone owns significant property like a house or something high-value like jewelry or other collector items, they will need additional policies tailored to these individual items. However, most people who rent will own the four major types listed above.

What Are All Risk Perils?

All risk perils is another name for all risk insurance as it relates to individual risks. Named perils is an insurance product that names what is insured in case of an accident. All risks, assuming there are no perils mentioned, could be considered all risk perils since all perils are assumed as risk (under the policy). However, these are rare as they put undue risk acceptance on the insurer, and it is much more common to see many perils listed, even on an all risks policy.

The Bottom Line

All risk insurance, also called all risk coverage, is an insurance product that covers any incident that isn’t explicitly mentioned. These policies assume a good deal of risk for the insurer and are less common than named risk coverage, which states exactly what is covered, versus stating only what is to be omitted (which is the case with all risk).

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19 Nov 2003

After-Hours Trading: How It Works, Advantages, Risks, Example

Written by admin. Posted in A, Financial Terms Dictionary

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What Is After-Hours Trading?

After-hours trading is securities trading that starts at 4 p.m. U.S. Eastern Time after the major U.S. stock exchanges close. The after-hours trading session can run as late as 8 p.m., though volume typically thins out much earlier in the session. Trading in the after hours is conducted through electronic communication networks (ECNs).

Key Takeaways

After-hours trading starts once the the day’s normal trading session closes at 4 p.m. and ends at around 8 p.m.
Premarket trading sessions are also available to investors, generally from 7 a.m. to 9:25 a.m.
After-hours trading and premarket trading is referred to as extended-hours trading.
Advantages of after-hours trading include convenience and opportunity.
Risks include low liquidity, wide bid-ask spreads, and order restrictions.

What’s After-Hours Trading?

Understanding After-Hours Trading

Traders and investors engage in after-hours trading for a variety of reasons. They may prefer trading with fewer market participants or their schedules may require it. They may want to take positions as a result of news that breaks after the close of the stock exchange. Or, they may want to close out a position before they leave on vacation.

Generally, after-hours trading refers to trading that takes place after normal market hours and up until about 8 pm. Premarket trading refers to trading that takes place before the start of normal market hours, generally from 7 a.m. until 9:25 a.m. Together, after-hours trading and premarket trading are referred to as extended-hours trading.

The precise times of extended-hours trading can depend on the ECN an investor uses or the financial institution where they place their orders. For instance, Wells Fargo allows after-hours trading from 4:05 p.m. ET until just 5 p.m.

Electronic markets (or ECNs) used in after-hours trading automatically attempt to match up buy and sell orders. If they can do so, trades are completed. If they can’t, trades remain unfilled.

After-hours trading typically only allows limit orders to buy, sell, or short, although a particular brokerage may be less restrictive. No stop, stop-limit, or orders with special instructions (such as fill or kill or all or none) are accepted. Moreover, orders are normally only good for the after-hours trading session in which they’re placed.

The maximum share amount per order is 25,000.

Quotes provided are limited to those available through the electronic market used. Investors may have access to other participating ECNs but it isn’t guaranteed.

Volume

In after-hours trading, the trading volume for a stock may spike on the initial release of news but most of the time thins out as the session progresses. The growth of volume generally slows significantly by 6 p.m. So, there is a substantial risk that investors will be trading illiquid stocks after-hours.

Price

Not only does volume sometimes come at a premium in the after-hours trading sessions, so does price. It is not unusual for the spreads to be wide in the after-hours. The spread is the difference between the bid and the ask prices. Due to fewer shares trading, the spread may be significantly wider than during the normal trading session.

Participation

If liquidity and prices weren’t enough to make after-hours trading risky, the lack of participants may do the trick. That’s why certain investors and institutions may choose not to participate in after-hours trading, regardless of news or events.

It’s quite possible for a stock to fall sharply in the after hours only to rise once the regular trading session resumes the next day at 9:30 a.m. Many big institutional investors have a certain view of price action during after-hours trading sessions and express that view with their trades once the regular market re-opens.

Since volume is thin and spreads are wide in after-hours trading, it is much easier to push prices higher or lower. Fewer shares and trades are needed to make a substantial impact on a stock’s price. That’s why after-hours orders usually are restricted to limit orders. If your brokerage doesn’t restrict them, consider them anyway as a means to protect yourself from unexpected price swings and order fills.

Standard Trading vs. After-Hours Trading

Standard Trading	After-Hours Trading
Orders placed anytime and executed from 9:30 a.m. to 4 p.m. ET.	Orders placed and possibly executed after 4 p.m. through 8 p.m.
Takes place on stock exchanges and Nasdaq via market makers and ECNs	Takes place via ECNs
No limit on order size	25,000 share maximum order size
No restrictions on order type	Orders normally restricted to limit orders
Orders can carry over to subsequent sessions	Orders normally expire in same trading session they’re placed
Wide variety of securities traded (stocks, options, bonds, mutual funds, ETFs)	Most listed and Nasdaq securities are available
Large volume, greater liquidity = executed trades	Orders may not get filled due to lower liquidity

Advantages of After-Hours Trading

The ability to place trades and have them filled in trading sessions that occur after normal stock exchange business hours can be important to some traders and investors. After-hours trading offers certain advantages.

Opportunity

Investors get the opportunity to trade on news that can move markets that’s released after the market closes or before it opens, such as the monthly jobs report or earnings reports. In addition, investors can take positions in response to unexpected events they believe may push prices higher (or lower).

After-hours trading may be an advantage to a dividend stock investor who misses the chance to buy a stock during regular market hours on the day before the ex-dividend date. The investor could try to buy it in after-hours trading in time to be eligible for the dividend.

Convenience

For any number of reasons, traders and investors may seek to trade after hours. For example, they may be occupied from 9:30 a.m. to 4 p.m. but still want to trade. Or, it might be part of a trading strategy to either take or close out positions when participants are fewer.

If the electronic communication network (ECN) that you’re using for after-hours trading suddenly becomes unavailable for technical reasons, your broker may try to direct orders to other participating ECNs so that they can continue to be filled. If this isn’t possible, a broker may find it necessary to cancel all orders entered for the after-hours session.

Risks of After-Hours Trading

If you’re considering after-hours trading, it’s important that you understand the risks associated with it. Bear in mind, these are on top of the inherent risks of stock trading.

In fact, some brokerages require that investors accept the ECN user agreement and speak with their brokerage representative before they’re allowed to trade, so that they fully grasp and accept those risks. Here’s a rundown:

Low liquidity: After-hours trading involves low volume trading. That means that investors may find it difficult (even impossible) to buy and sell stocks.
Price uncertainty: You may not see or get filled at the best available price since the prices/quotes available during after-hours trading are those provided by, usually, one ECN. They aren’t the consolidation of the best available prices that occurs in normal trading sessions.
Price volatility: Low liquidity results in volatile prices, which can make orders a challenge to fill.
Wider than normal bid-ask spreads: These can indicate an illiquid security, which can be difficult to buy or sell.
Competition: Professional traders abound in after-hours trading. This can spark volatility and the potential for greater than normal losses for less experienced investors.
Restricted orders: Depending on the ECN and brokerage, after-hours trading may be restricted to limit orders, which may mean your trades go unfilled.

Example of After-Hours Trading

Nvidia Corp. (NVDA) earnings results in February 2019 are an excellent example of the challenge of after-hours trading and the dangers that come with it. Nvidia reported quarterly results on Feb. 14. The stock was greeted by a big jump in price, rising to nearly $169 from $154.50 in the 10 minutes following the news.

As the chart shows, volume was steady in the first 10 minutes and then dropped quickly after 4:30 p.m. During the first five minutes of trading, around 700,000 shares traded and the stock jumped nearly 6%. However, volume slowed materially with just 350,000 shares trading between 4:25 and 4:30. By 5 p.m., volume measured only 100,000 shares, while the stock was still trading around $165.

However, the next morning was a different story. When the market opened for normal trading, traders and investors had a chance to weigh in on Nvidia’s results. From 9:30 a.m. 9:35 a.m., nearly 2.3 million shares traded, more than three times the volume in the initial minutes of the previous day’s after-hours trading. The price dropped from $164 to $161.

The stock proceeded to trade lower throughout the rest of the day, closing at $157.20. That was just $3 higher than the previous day’s close. Moreover, it was a plummet from the nearly $15 increase made in the after-hours session. Sadly, nearly all of the after-hours gains made by investors during that session had evaporated.

Does After-Hours Trading Affect Opening Price?

It certainly can. Since a great deal of trading may be taking place after hours, prices of securities can change from their levels when the regular market previously closed.

Can You Actually Trade After Hours?

Yes, provided your brokerage authorizes you to do so. You’ll first want to make sure you clearly understand how after-hours trading works and the risks involved in it. Your brokerage may ask that you meet with a investment representative to make sure you know the difficulties posed by after-hours and premarket trading.

Why Can Stocks Be So Volatile in After-Hours Trading?

Lower trading volume and less liquidity results when fewer traders and investors are in the market. This causes wider bid-ask spreads and, in turn, greater stock price volatility. This is the challenging trading environment that can exist in after-hours trading.

The Bottom Line

After-hours trading of securities occurs after the close of the regular trading session at 4 p.m. ET and can last until about 8 p.m. ET. While it offers investors certain advantages, it also can be quite risky. So, in addition to understanding those risks, be sure to consider your investing goals, your tolerance for risk, and your trading style before getting involved.

Most investors may want to stick with the familiar buy and hold strategy that can be executed during normal trading sessions. However, for those prepared for it, after-hours trading may be a useful investment tool and worth trying out.

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19 Nov 2003

Agency Problem: Definition, Examples, and Ways To Minimize Risks

Written by admin. Posted in A, Financial Terms Dictionary

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What Is an Agency Problem?

An agency problem is a conflict of interest inherent in any relationship where one party is expected to act in another’s best interests. In corporate finance, an agency problem usually refers to a conflict of interest between a company’s management and the company’s stockholders. The manager, acting as the agent for the shareholders, or principals, is supposed to make decisions that will maximize shareholder wealth even though it is in the manager’s best interest to maximize their own wealth.

Key Takeaways

An agency problem is a conflict of interest inherent in any relationship where one party is expected to act in the best interest of another.
Agency problems arise when incentives or motivations present themselves to an agent to not act in the full best interest of a principal.
Through regulations or by incentivizing an agent to act in accordance with the principal’s best interests, agency problems can be reduced.

Understanding Agency Problems

The agency problem does not exist without a relationship between a principal and an agent. In this situation, the agent performs a task on behalf of the principal. Agents are commonly engaged by principals due to different skill levels, different employment positions, or restrictions on time and access. For example, a principal will hire a plumber—the agent—to fix plumbing issues. Although the plumber‘s best interest is to collect as much income as possible, they are given the responsibility to perform in whatever situation results in the most benefit to the principal.

The agency problem arises due to an issue with incentives and the presence of discretion in task completion. An agent may be motivated to act in a manner that is not favorable for the principal if the agent is presented with an incentive to act in this way. For example, in the plumbing example, the plumber may make three times as much money by recommending a service the agent does not need. An incentive (three times the pay) is present, causing the agency problem to arise.

Agency problems are common in fiduciary relationships, such as between trustees and beneficiaries; board members and shareholders; and lawyers and clients. A fiduciary is an agent that acts in the principal’s or client’s best interest. These relationships can be stringent in a legal sense, as is the case in the relationship between lawyers and their clients due to the U.S. Supreme Court’s assertion that an attorney must act in complete fairness, loyalty, and fidelity to their clients.

Minimizing Risks Associated With the Agency Problem

Agency costs are a type of internal cost that a principal may incur as a result of the agency problem. They include the costs of any inefficiencies that may arise from employing an agent to take on a task, along with the costs associated with managing the principal-agent relationship and resolving differing priorities. While it is not possible to eliminate the agency problem, principals can take steps to minimize the risk of agency costs.

Regulations

Principal-agent relationships can be regulated, and often are, by contracts, or laws in the case of fiduciary settings. The Fiduciary Rule is an example of an attempt to regulate the arising agency problem in the relationship between financial advisors and their clients. The term fiduciary in the investment advisory world means that financial and retirement advisors are to act in the best interests of their clients. In other words, advisors are to put their clients’ interests above their own. The goal is to protect investors from advisors who are concealing any potential conflict of interest.

For example, an advisor might have several investment funds that are available to offer a client, but instead only offers the ones that pay the advisor a commission for the sale. The conflict of interest is an agency problem whereby the financial incentive offered by the investment fund prevents the advisor from working on behalf of the client’s best interest.

Incentives

The agency problem may also be minimized by incentivizing an agent to act in better accordance with the principal’s best interests. For example, a manager can be motivated to act in the shareholders’ best interests through incentives such as performance-based compensation, direct influence by shareholders, the threat of firing, or the threat of takeovers.

Principals who are shareholders can also tie CEO compensation directly to stock price performance. If a CEO was worried that a potential takeover would result in being fired, the CEO might try to prevent the takeover, which would be an agency problem. However, if the CEO was compensated based on stock price performance, the CEO would be incentivized to complete the takeover. Stock prices of the target companies typically rise as a result of an acquisition. Through proper incentives, both the shareholders’ and the CEO’s interests would be aligned and benefit from the rise in stock price.

Principals can also alter the structure of an agent’s compensation. If, for example, an agent is paid not on an hourly basis but by the completion of a project, there is less incentive to not act in the principal’s best interest. In addition, performance feedback and independent evaluations hold the agent accountable for their decisions.

Real-World Example of an Agency Problem

In 2001, energy giant Enron filed for bankruptcy. Accounting reports had been fabricated to make the company appear to have more money than what was actually earned. The company’s executives used fraudulent accounting methods to hide debt in Enron’s subsidiaries and overstate revenue. These falsifications allowed the company’s stock price to increase during a time when executives were selling portions of their stock holdings.

In the four years leading up to Enron’s bankruptcy filing, shareholders lost an estimated $74 billion in value. Enron became the largest U.S. bankruptcy at that time with its $63 billion in assets. Although Enron’s management had the responsibility to care for the shareholder’s best interests, the agency problem resulted in management acting in their own best interest.

What Causes an Agency Problem?

Agency problems arise during a relationship between a principal and an agent. Agents are commonly engaged by principals due to different skill levels, different employment positions, or restrictions on time and access. The agency problem arises due to an issue with incentives and the presence of discretion in task completion. An agent may be motivated to act in a manner that is not favorable for the principal if the agent is presented with an incentive to act in this way.

What Is an Example of Agency Problem?

In 2001, energy giant Enron filed for bankruptcy. Accounting reports had been fabricated to make the company appear to have more money than what was actually earned. These falsifications allowed the company’s stock price to increase during a time when executives were selling portions of their stock holdings. When Enron declared bankruptcy, it was the largest U.S. bankruptcy at that time. Although Enron’s management had the responsibility to care for the shareholder’s best interests, the agency problem resulted in management acting in their own best interest.

How to Mitigate Agency Problems?

While it is not possible to eliminate the agency problem, principals can take steps to minimize the risk, known as agency cost, associated with it. Principal-agent relationships can be regulated, and often are, by contracts, or laws in the case of fiduciary settings. Another method is to incentivize an agent to act in better accordance with the principal’s best interests. For example, if an agent is paid not on an hourly basis but by the completion of a project, there is less incentive to not act in the principal’s best interest.

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