Beat the Rush and Profit

In the wake of the bankruptcy of Lehman Brothers, fallout from Hurricane Ike, and worries across the financial markets, yesterday's 500-point drop in the Dow didn't surprise anyone who's been following stocks for a while.

What often shocks beginning investors, however, is how people knew well in advance that the stock market would tank on Monday morning. As early as Sunday night, analysts were predicting the big drop in the market yesterday. More often than not, as happened yesterday, those predictions turn out to be correct.

Do these people have some sort of psychic powers? And more importantly, is there a way to profit by jumping the gun on the opening bell?

There's nothing mystical about predicting how the market will open. With a little training, you can read the same tea leaves that more experienced investors use -- or use them yourself to get an edge with your own investing.

A whole other market
When you're just getting started with investing, you don't necessarily have to pay much attention to how markets function. Mutual fund investors, for example, only need to pay attention to the market close. Because most mutual funds only allow investors to buy and sell once every day, the hourly gyrations of various stocks throughout the trading day don't have any impact on the price you'll pay or receive for mutual fund shares.

When you start buying individual stocks, you start to see a little more of the internal workings of the market. When you buy during the day can make a big difference, depending on how much share prices fluctuate during the day.

I can't wait!
Once you've gotten used to buying on demand, dealing with the market being closed gets tougher. The vast majority of stock trading happens during the market's regular hours: 9:30 a.m. to 4 p.m. Eastern time. However, if you don't want to wait for the market to open, you have several alternatives.

First, so-called extended trading, which uses electronic exchanges, has become available to many investors through online brokerages. For many brokers, pre-market extended hours begin at 8 a.m., while after-hours trades can be made until 8 p.m. Eastern. You have to be careful trading these markets, as volume is low and sometimes prices can move sharply.

Also, sophisticated traders use futures contracts to trade large baskets of stocks. With electronic trading, futures exchanges are open nearly 24 hours a day, from Sunday evening to Friday afternoon, making it possible for investors to act well in advance of the market's Monday morning open.

In fact, futures are how those commentators predict where the market will open.

Reading the future with futures
Most people think of commodities when they hear about futures. But there are also futures contracts on a variety of financial markets, including stock index futures.

By looking at the price of stock futures contracts, you can get an indication of how the market will open. Although futures don't track indexes perfectly, a mathematical calculation known as fair value tells you how they relate. So if fair value for the S&P futures is +2, futures will typically trade 2 points higher than the current index.

Even while the market is closed, however, futures will often make big moves. For instance, on Sunday night and Monday morning, S&P futures were down as much as 50 points, forecasting the big drop. Once the market opened, traders sold the actual stocks until the futures were closer to their fair value.

You can estimate what effect a move in futures will have on particular stocks. With S&P futures down about 40 points when the market opened Monday, shares in the S&P should have fallen by about 3.4%. Here's what actually happened for a sampling of stocks that typically follow the market indexes closely:

Sources: Yahoo! Finance, futuresource.com.

As you can see, many shares opened fairly close to their predicted values. However, the relationship isn't perfect -- some stocks will perform better than the overall index, while others will do worse.

So if you want to know how stocks will open in the morning, don't pull out your Ouija board -- just watch the futures markets. And to get a jump on the trading competition, extended trading is worth looking into as well.

For more on smart investing, read:

• Are value stocks ready to break out?
• The unprecedented investing opportunity in global stocks.
• Black Sunday on Wall Street.