- 2001: Volume 10, No. 1 Trading the News

There are many ways to profit from the effects of news stories. Everyone has heard the saying, "Buy the rumor. Sell the news." Stocks often rise as a rumor develops and continue upward until news that confirms or negates the rumor appears. Then the decline begins, even when the news is good. Why? "Insiders" buy early, knowing the rumor will fuel additional buying by the public. When the news is released, the insiders liquidate their long positions; the news creates a rush of buyers, making it easy to sell at a good price. The naive public’s buying frenzy occurs as smarter traders and those "in the know" take their profits. As the smart traders sell to the last wave of public buyers, prices drop. There is no one left to buy. When the last buyers panic and sell, the decline accelerates. In short, once news is released and widely disseminated, the inefficiency in the market disappears. This is one approach to using the news in trading.

Another approach is to trade the reversal that often occurs when the news is finally released. This may be done by day trading news-induced overnight gaps. Such gaps are frequently the result of the public overreacting to the news, causing prices to deviate sufficiently from fair value so as to allow a savvy trader to profit. Consider a headline such as "XYZ Corporation Reports Record Earnings." If the story appears before the market opens, chances are the stock will open on a gap as market makers raise prices in response to the flood of public orders to buy the stock. During the day, profit takers will enter the market, selling into the demand, thus bringing prices down to a more reasonable level. Or consider a story such as "ABC Corporation Sued by Shareholders." If this news was released at some point after yesterday’s close, but before today’s open, the stock is likely to gap down, opening low. In response to the news, many stockholders will decide to sell. Sell orders pile up at the open, driving prices down. The decline will typically be excessive and, during the day, savvy buyers will come in and take advantage of the bargain prices, causing at least some retracement or bounce.

Some traders might wonder why we have not mentioned after hours markets, e.g., as on the various ECNs. The reason is that these markets seem to have little neutralizing effect. Great news still tends to push stocks to excessive highs on the normal opening bell and bad news, conversely, tends to push stocks to exaggerated lows. Examination of after hours trading, however, can be useful in revealing whether the news is having the expected impact.

The Steps Involved
Trading overreactions to news at the open is a great way to day trade. The basic steps to this form of trading are:

1. Before the market opens, examine your favorite news service (we use businesswire.com) and search for stories appearing sometime after the market closed yesterday but before it opens today. Look for stories that have extreme and unambiguous positive or negative headlines. "Great Company Inc. Shows All Time Record Profits" and "Fly-by-Night Corp. Loses Fraud Case" are two such examples.
2. Call up a several day charts for each of the stocks having such news to examine their price behavior prior to its release. If the news is good, the stock should have been rising in anticipation of the breaking story. If the news is bad, the stock should have been declining.
3. Set up your real-time screens and charting for the stocks you have selected. Be ready to act quickly when the market opens. If the news on a given stock is good, look to short the stock, or to perhaps buy a put, on an opening gap in which prices open high. The idea is to capture some profit as prices fall back during the day to more reasonable levels. Likewise, buy at the open on a gap down overnight. You should profit during the day from the expected bounce in prices.
4. Take your profits anywhere from 15 minutes to several hours later in the day by covering short positions or selling long ones. A good rule-of-thumb for profit taking is that a stock will often retrace approximately 50 percent of the runnup or rundown that occured in anticipation of the newly released news. In many cases, you will experience substantial profit opportunities. In the case of stocks, these profits can be somewhere between five percent and 15 percent during the course of the day.

Examples
To find examples for discussion, we scanned headlines that appeared on businesswire.com, our favorite news source. On December 4, 2000, a beginning news trader might have noticed the following headlines: "Cardinal Health and Bindley Western Industries Agree to .1 Billion Merger" (appeared 06:31 EST), "UniComp Inc. Sells Unibol Ltd. and Terminates Merger Talks With California Software Corp." (07:31 EST), "Syscan Announces First Quarter Financial Results; Revenues Up 75 percent; Record Order Backlog" (08:22 EST), and "General Magic Awarded ‘Voice User Interface With Personality’ Patent; An Industry Milestone in Improving Customer Service Over the Phone" (08:47 EST). An experienced news trader would have rejected the first two headlines, which involved mergers. There is nothing powerful and unambiguous enough in them to compel the public to either buy or sell the stocks. Does a merger mean that one of the companies merging will rise? Or will it fall? Likewise, the effect a termination of merger talks will have on a given stock is unclear, especially from the headlines themselves. These are not the kind of headlines that catch the eye of a skilled news trader. The announcement of higher revenues and order backlogs, however, would be expected to lead to excessive public response of the kind that could cause a tradeable bounce during the day; however, we were unable to get the data for this particular stock, so it was rejected as a possible play. The last headline, although not the best one could hope for, was at least acceptable. The charts for General Magic (GMGC) showed the proper setup, in that there was an overnight gap up to a price not far from the high of the preceding two days. This can be seen in the longer term chart in Figure 1, which shows the trading day, as well as the four days prior to the news release.

Figure 1:

Figure 2 shows an intraday chart of the trading day. As can be seen, one could easily have shorted the stock either immediately at the open or around 10:00, obtaining a price somewhere between 2-3/4 and 2-7/8. Many opportunities existed to cover the shorts at around 2-9/16 between 12:00 and 15:00. This is the time we would have attempted to take our profit. Had we worked the stock using limit orders, we would have made a quarter point profit on a 2-3/4 stock, a profit of approximately 10 percent of the stock’s value. Had one held the position until the close, when the stock reached a low of under 2-5/16, a half point profit would have been made. This illustrates the typical behavior of a stock for this kind of news trade.

Figure 2:

The same student of ours thought the following headlines on December 5, 2000 were interesting: "Alaska Communications Systems Experiences Dramatic Growth from its ‘Infinite Minutes’ Plan; Over 19,000 Customers Since October 2, 2000" (01:02 EST), "Berman DeValerio & Pease Announces Class Action Lawsuit Against Twinlab Corporation" (06:45 EST), "ARID Announces Progress With ARGENT Stem Cell Therapy at American Society of Hematology Meeting" (07:59 EST), and "Conoco Confirms U.K. Oil and Gas Finds of More Than 100 Million BOE" (08:06 EST). The stock referred to in the first headline evidenced no gap at the open and so was rejected as a potential candidate. The second choice presented had news that would be decidedly unpleasant to stockholders, but there was no overnight gap. Examining the past several days of activity suggested that much of the news had already been incorporated into the stock price. It is interesting to note, however, that the stock started to decline after 11:00; perhaps some of the impact of the news occurred later in the day than would be expected. Nevertheless, without a sizeable overnight gap from which a retracement might occur, one does not take a news trade of this kind. A gap, representing an overreaction from which there can be a bounce, must be present. The third headline was about an announcement that had already occurred at a conference, thus old news that was already in public view. It was also a weak story, one about "progress," something that rings of public relations and marketing, rather than something more definitive that would compel investors to act. The headline about Conoco looked good, even though it was not as strong as preferred, but it was unambiguous and there was a gap up at the open. In addition, the opening price was near the high of the last three days. Figure 3 is of a five-day chart (including the trading day) that shows the opening gap.

Figure 3:

Figure 4 depicts the stock’s behavior on the trading day. As can be seen, this would have made a fairly good trade. One could have shorted the stock at the open, in anticipation of the expected retracement, for somewhere between 25-1/4 and 25-3/8. The short could easily have been covered at 24-7/8 or better at any of several times throughout the day. This would have yielded a profit of 3/8 of a point, smaller than usual for this kind of news trading, but not bad for a trade that might only last an hour or so.

Figure 4:

Conclusion On the basis of our experience, day trading overreactions to the news can be highly profitable. In addition, adverse movements tend to be minimal since the news trader is entering positions after the news has been absorbed into the market. The main problem with this kind of news trading is that it is sometimes difficult to find the extreme, unambiguous news that produces the best results. You can read more about trading on the basis of the news in our book, How To Start Day Trading Futures, Options, and Indexes.

Jeffrey Owen Katz, Ph.D., is a professional trader, instructor at the New York Institute of Finance, and consultant in Selden, NY, whose firm, Scientific Consultant Services Inc., specializes in trading instruction, custom research, as well as forecasting software and systems. Readers are welcome to contact him at katz@scientific-consultants.com or (631) 696-3333.

Donna L. McCormick is vice president of Scientific Consultant Services, Inc., and has co-authored (with Katz) The Encyclopedia of Trading Strategies and How to Start Day Trading Futures, Options, and Indexes.