What would stop someone from taking advantage of wide bid-offer spreads in extended hours trading via short selling?

Question

I understand that the less volume occurring in a security, the less liquidity (the wider the bid-offer spread). So my question is, in pre-market and after-hours trading, when bid-offer can widen significantly on lower volume securities (or on securities where volume lessons period regardless of overall daily volume), is it not feasible that you could buy SHORT the ask of XYZ at, say 150, then immediately sell at the lower bid of 148 for a quick 1.25% return? Or would hitting the ask push the current bid-offer spread up virtually the same percentage no matter what? This is assuming the position is nothing significant that would normally move the spread and there are other active traders at the moment, not like some grand lone trade that stands out. So would it move the spread or can this be done? I do not trade on margin yet so I can't try this myself and I couldn't find any info regarding this trade technique. Any rules or regulations regarding this.

Answer 1

In equilibrium, there is no money to be made on the large spreads that is not related to the risk of trading. When multiple traders begin to believe there is money to be made, competition between them can quickly lower the spread to a level where the profits are only compensating for the risk of trading.

Let's see how this works with your example.

Trades on the market always occur between a buyer and a seller. Use this and the definitions of the market bid and ask and you will see that there is no immediate profit of "2" between 148 and 150 to be captured and any attempt to capture the profit of "2" over time invites risks and may fail.

Here is your example:

XYZ Bid: 148 Ask: 150

The proposed strategy is to short at 150 and buy at 148.

First, notice this can not happen immediately:

If you want to short XYZ, at the moment the highest bidder will pay 148 and the cheapest seller wants 150.

The cheapest seller will take 150 to sell his shares to someone. He doesn't want to buy shares -- he wants to sell, just like you. So you can not sell to him at 150.

Similarly, you can not buy at 148, as this is the price that another buyer is willing to pay for shares. If you are also buying, you are competitors and are both trying to buy. A trade occurs between a buyer and a seller and this strategy does not immediately work with what the other participants on the market currently want to do.

Once you see that there is no way to immediately earn 2, we will look at the strategy of putting in both orders and waiting: Note that you can put in an order to sell short at 149.99 and it will sit waiting for execution, and also put in an order to buy at 148.01, and it will sit waiting for an execution.

Eventually, and perhaps with some luck, other traders will take both of these orders and you will profit by 1.98 [not quite 2, because I've assumed the strategy is to compete against the bid and ask in order to replace them and be first in line to trade] . But that is not the only possibility. It is also possible that only one of the offers is taken, and you are stuck with a long or short position that moves against you. You can then either wait for it to hit the other number, and accept the paper losses and margin calls in the meantime, or you can lock in a loss. These losses will act against the profits made when others take both orders.

If it really made money to trade both buying and selling inside the spread, someone else could come along and bid 148.02 and ask 149.98. There are well paid quantitative experts and computers that study these fluctuations continuously. If the spread is too wide, these automated trading programs may jump in, lowering the spread. Are you equipped to pick which spreads are good gambles and which are not, relative to the adversaries competing in this arena?