What Is a Reaction?
A reaction, in the context of financial markets, is a sudden but usually short-lived upwards or downwards movement in a stock's price. Technical analysts often describe a downward movement in the price of a stock after a period of upward movement as a reaction.
Reactions are typically responses to news or data relevant to the company that issued the stock or the industry it operates in. The change in price tends to be slight.
- A reaction is a brief movement in price, often in response to news or to the release of new data.
- A reaction may last for only a few sessions before reverting back to the prevailing trend.
- A true reversal or price correction is deeper and more prolonged than a short-lived and muted reaction.
Understanding a Reaction
Reactions are generally considered to be a positive and normal occurrence in a healthy market. Unending price increases can result in an even larger price drop if a company doesn't meet expectations or hits any other snag.
In fact, an occasional reaction is likely to prevent an event such as a run on a stock or a high volume sell-off at a later date.
An overreaction is an extreme response to new information. In finance and investing, it is an emotional response to a security such as a stock or other investment, which is led either by greed or fear. Investors overreacting to news cause the security to become either overbought or oversold until it returns to its intrinsic value.
Good News and Bad News
A downward reaction is often a response to negative news. That news could be a bad earnings report, a critical story about the company, economic and political uncertainty, and any unexpected and unfortunate occurrence. Any or all of these can cause selling pressure and a decrease in stock price.
Positive news will normally cause prices to rise, however briefly. An announcement of a new product, an acquisition, or the release of an upbeat economic indicator all can cause a positive reaction in a stock's price.
These events can be truly ephemeral. A hurricane approaching landfall can cause a drop in utility stocks and insurance stocks. Hours later, an announcement that the storm has drifted offshore can turn prices around.
A reaction can provide an entry point for a trader looking to enter a position when other technical indicators remain bullish.
Reactions vs. Reversals
Reactions can be shrugged off, especially by investors who are in it for the long haul. Reversals are more serious and can be long-lasting. Traders need to be able to distinguish between the two.
Most reversals involve a change in a security’s underlying fundamentals that forces the market to reevaluate its value. If a company reports a disastrous quarter, investors will recalculate the stock’s net present value and act accordingly. Or, a competitor's release of a game-changing new product can do long-term damage to a stock's value.
Events that will turn out to be significant will initially seem like a reaction. But if they play out over several sessions, a true reversal may be underway.
This is why traders use moving averages, trendlines, and trading bands to flag the point at which reaction risks entering reversal territory.