How To Trade The News

By Elvis Picardo, CFA AAA

Two savage bear markets within the first decade of this millennium have made many investors question the wisdom of adhering to a “buy and hold” strategy for stocks. Although equity markets may display a sustained upward trend over long time periods, it’s the intermittent tailspins – such as the 50% plunges endured by most major markets during the 2008-09 global credit crisis – that test the fortitude of any investor.

Trading the news, then, should be an integral component of your investing strategy. While day traders may trade the news several times in a trading session, longer-term investors might do so only occasionally. Regardless of your investing horizon, learning to trade the news is an essential skill for astute portfolio management and long-term performance.

Classifying News

News can be broadly classified into two categories:

  • Periodic or recurring – News that is issued at regular intervals. For example, interest rate announcements by the Federal Reserve and other central banks, economic data releases and quarterly earnings reports from companies all fall into this category.
  • Unexpected or one-time This category includes “bolts from the blue” such as terrorist attacks or sudden geopolitical flare-ups, as well as abrupt market developments on the economic or financial front like the threat of debt default by an indebted nation. Unexpected news is more likely to be adverse than favorable.

News can be specific to a particular stock or something that affects the broad market.

Trading the News

Let’s use a few examples to demonstrate these concepts:

1. Federal Reserve rate announcement: The Federal Open Market Committee’s (FOMC) interest rate announcements have always been among the biggest market-moving events. But in 2013, the Fed’s moves assumed unparalleled importance, as investors waited with bated breath to see if the central bank would continue to inject $85 billion monthly into the U.S. economy through bond purchases (the third round of quantitative easing or QE3), or if it would slow the pace of these purchases. Given that U.S. equity indices were at record highs in October 2013, an investor with a substantial long position in U.S. stocks who was looking to hedge potential downside risk could have done the following right after the Fed’s Oct. 30 announcement:

  • Trimmed positions in highly profitable equity positions to take some money off the table.
  • With market volatility near multi-year lows at that time, the investor could have purchased puts either on specific stocks in the portfolio or on a broad market index like the S&P 500 or Nasdaq 100. Purchasing puts gives the investor the right to sell a stock for an agreed-upon price at some future time. If the security's market price falls below the agreed-upon price, the investor gains by selling at the higher contractual price.
  • Bought a certain amount of inverse exchange traded funds (ETFs) – which move in the opposite direction of the broad market or a specific sector – to protect portfolio gains.

While these reactive moves would typically be carried out after the Fed announcement, a proactive investor could implement these same steps in advance of the Fed statement. This reactive or proactive approach to an important event or piece of news, of course, depends on a number of factors, such as whether the investor has a high degree of conviction about the market’s near-term direction, risk tolerance, trading approach (passive or active) and so on.

 

2. U.S. employment situation summary (the “jobs report”): In terms of economic data releases, few are more important than the U.S. jobs report. Traders and investors closely watch the employment level, since it has a substantial influence on consumer confidence and spending, which accounts for 70% of the U.S. economy. Jobs numbers that miss economists’ forecasts are generally interpreted as signs of incipient economic weakness, while payroll numbers that surge past forecasts are seen as strength. In the summer of 2013, investors were unfazed by payroll numbers that came in below expectations, in the belief that any signs of economic weakness would cause the Fed to keep QE3 going. The investor playbook for trading jobs data in 2013 could be easily based on predictable market reaction, which was as follows:

  • Payroll numbers below expectations: Implies that the Fed would be forced to keep interest rates low for an extended time period. The impact on specific asset classes was typically as shown in the table:

Asset/Instrument

Immediate Impact

Equities

Bonds

US dollar

Volatility

Gold

↔ (no clear trend)

Commodities

↔ (no clear trend)

 

  • Payroll numbers above expectations: Implies that the Fed may scale back the pace of asset purchases, which could send bond yields and market interest rates higher.

Asset/Instrument

Immediate Impact

Equities

Bonds

US dollar

Volatility

Gold

↔ (no clear trend)

Commodities

↔ (no clear trend)

 

An investor could use these market reactions to formulate an appropriate trading strategy to implement either in advance of the jobs report or after its release.

 

3. Earnings reports: It is generally advisable to have a trading strategy in advance of an earnings report, because a stock can bounce around in a much wider range post-earnings, as compared to the swings in an index after a data release. Imagine having a huge short position in a stock and watching it soar 40% in the after-market because its earnings were much better than expected.

Trading earnings reports may not be required for every stock in one’s portfolio, but it may be necessary for a stock where the investor has a fairly large position, whether long or short. In this case, the investor needs to weigh the merits of leaving the position unchanged over the earnings report or making changes prior to it. Factors that should play a part in this decision include:

  • The current state of the overall market (bullish or bearish);
  • Investor sentiment for the sector to which the stock belongs;
  • Current level of short interest in the stock;
  • Earnings expectations (too high or comfortably low);
  • Valuations for the stock;
  • Its recent and medium-term price performance;
  • Earnings and outlook reported by the competition, etc.

For example, an investor with a 15% position in a big-cap technology stock that is trading at multi-year highs may decide to trim positions in it ahead of the earnings report, so that it now constitutes 10% of the portfolio. This may be preferable to taking the risk of a steep decline post-earnings if the stock is unable to meet investors’ high expectations. An alternative option could be to buy puts to hedge downside risk. While this would enable the investor to leave the position unchanged at 15% of the portfolio, this hedging activity would incur a significant cost.

It may also make sense to trade an earnings report for a stock where the investor does not have a position but (rightly or wrongly) has a high degree of conviction. Key points to note are – avoid taking an unduly large position, and have a risk mitigation strategy in place to cap losses if the trade does not work out.

 

4. Bolts from the blue: What should you do if the screens suddenly flash news of a terrorist attack somewhere in the United States, or war looks imminent between two nations in the volatile Middle East? While this is one time when you may need to be proactive to protect your investment capital, a kneejerk reaction to sell everything and take to the hills may not be the best course of action. Over the years, financial markets have demonstrated a great deal of resilience by taking in stride the occasional terrorist attack, such as the bomb blasts at the Boston Marathon's conclusion on April 15, 2013.

During times of geopolitical uncertainty, it may be prudent to rotate out of more speculative instruments and into higher-quality investments, and consider hedging downside risk through options and inverse ETFs. While you should scale back your equity exposure if it is uncomfortably high, bear in mind that in the majority of cases, the short-term corrections caused by unexpected geopolitical or macroeconomic events have proved to be quintessential long-term buying opportunities.

Tips for New News Traders

  • Know the dates and times of important events: Information on the dates and times of key market events such as FOMC announcements, economic data releases and earnings reports from key companies is readily available online. Know this “calendar of events” in advance.
  • Have a strategy in place beforehand: You should plot your trading strategy in advance, so that you are not forced into making rash decisions in the heat of the moment. Know your exact trading entry and exit points before the action begins.
  • Avoid kneejerk reactions: Rather than kneejerk reactions, make rational investing decisions based on your risk tolerance and investment objectives. This may require you to be a contrarian on occasion, but as successful long-term investors will attest, this is the best approach for successful equity investing.
  • Cap your risk levels: Avoid the temptation of trying to make a fast buck by taking a concentrated long or short position. What if the trade goes against you?
  • Have the courage of your convictions: Assuming you’ve done your homework, consider adding to an existing position if the stock plunges to a level below its intrinsic value, or conversely, selling out to take profits in a stock that is wildly popular at the moment.
  • See the big picture: Often, investor reaction to a development may not be as expected. For example, Canadian natural gas company EnCana (ECA) slashed its dividend by 65% on Nov. 5, 2013. While a dividend cut of this magnitude would normally send a stock plunging, EnCana actually rallied 3% on the day. This was because investors viewed the dividend cut as a cash-saving measure, and they also approved the company’s plans to sell shares in a new royalty company.
  • Don’t be swayed by market sentiment: This is a corollary to some of the earlier tips, and it is important enough in its own right. Being overly swayed by market sentiment may result in too many instances of buying high – when euphoria runs rampant – and selling low, when gloom and doom prevails. Consider the plight of the many hapless investors who were so spooked by the unrelenting tide of bad news in 2008 that they exited their equity positions near the lows, incurring massive losses in the process. Numerous investors failed to get back into equities after that horrendous experience, and in the process, missed out on a stunning gain of 166% in the S&P 500 from March 2009 to October 2013.
  • Know when to "fade" the news: Many times it is as important to ignore the news or “fade” it as it is to trade it. Best Buy (NYSE:BBY) is a great example of a stock where ignoring the steady drumbeat of bad news, and focusing instead on its valuations and turnaround prospects, would have paid off handsomely. The stock was trading at a decade-low $11.20 in December 2012, as it was losing market share to online rivals like Amazon.com (Nasdaq:AMZN) and aggressive retailers such as Wal-Mart (NYSE:WMT). But as of Nov. 6, 2013, it was the third-best performer on the S&P 500 for the year, having nearly quadrupled in price as profits surged thanks to cost-cutting measures and competitive product pricing.

The Bottom Line

Trading the news is crucial for positioning your portfolio to take advantage of market moves and boost overall returns.

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