RESEARCH NEWS

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Timing the Market: Unlock the Secret Behind Smarter Trading Strategies

FINANCE

Summary by Laura Bilbao, Director of Research & Outreach

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Why do trading volumes and transaction costs usually rise and fall at the same times of day? And why are these swings even more dramatic during market uncertainties? 

Using a dynamic trading model, Dr. Wen Chen, Ph.D., and her colleague found that a familiar U-shaped pattern may stem from the power of market makers, firms ready to buy and sell securities, and the motivations traders have to perform these same transactions. Critics argue that dominant market makers may over- influence pricing and trading conditions. Supporters claim they help markets operate more efficiently.  

The study focuses on two major forces that drive trading activity: 

• Private information: Believing they possess valuable, predictive information, some traders bid early in the day, hoping to profit before news spread.
• Liquidity needs: Other traders act for practical reasons, such as hedging risk, rebalancing portfolios, or raising cash. They postpone transactions until trading conditions improve, if at all, later in the day.

Trading volume patterns become more pronounced when there is less information asymmetry or when markets contain a higher proportion of liquidity traders. When it comes to transaction costs, the study found that market makers tend to widen bid-ask spreads when traders have stronger trade incentives and when there is a higher risk of trading against better-informed investors. As a result, the gap between buying and selling prices becomes largest near market opening and closing.

Recognizing these patterns can help traders make more informed decisions about when to execute transactions: investors may face higher costs near market opening and closing, while traders seeking lower costs may prefer to place orders during quieter periods of the day. Those responding to new information may deliberately trade when activity is highest and liquidity is abundant. 

Ultimately, understanding how market conditions evolve throughout the trading day can help market participants better balance execution costs, timing, and risk. 

Wen Chen, Yajun Wang, Dynamic Market Making with Asymmetric Information and Market Power, The Review of Financial Studies, Volume 38, Issue 1, January 2025, Pages 235–293, https://doi.org/10.1093/rfs/hhae062

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