3 Reasons You Can’t Trade the News
“The market anticipates, while the news exaggerates.”
— Bob Farrell
You can’t trade the news.
Well, you can. But you shouldn’t. In fact, I would go as far as to say there’s no strategy to successfully gauge how a news event or story will play out in the markets.
Remember the fiscal cliff debacle just a couple of months ago? The media played up every angle of the cliff, how it would end in disaster and probably ruin the economy and the markets. Politicians argued. They missed deadlines — then they kicked the can, without any real solution to the whole debt issue.
That’s when the market began to rally…
It’s a perplexing phenomenon for those who aren’t in tune with technical analysis. After all, humans are constantly seeking organization in a highly unorganized world. So when the markets fail to follow the script we’ve been given, we just don’t know what to make of all of it. That’s the big problem with trading on events and news stories. The market’s already three steps ahead of you.
If you’re going to rely on price action to guide your trading, you need to understand the three main reasons you can’t think like a news trader:
1. Correlation does not equal causation
Every single day, without fail, the financial media will post their market wrap-ups. They’ll summarize the day’s activity, give you the closing prices for the major exchanges and maybe even throw in a couple of foreign markets if there was any action overseas.
Of course, these numbers are not reported alone. There’s always a reason assigned for the gains or losses of the day. Stocks moved lower because of poor manufacturing data. Or they moved higher because of strong earnings from a couple of blue chips.
But is it true? Did the market (and its countless participants) collectively decide to move higher or lower for those specific reasons? It’s impossible to know for sure, yet it is reported as fact every single day.
Famed technician Ralph Acampora says that an event can be discounted once — and only once.
So what does this mean?
Let’s say the market gets rocked by an unexpected announcement. The major averages fall more than 1%. And for the next week or so, additional news stories about this event continue to dissect and project what it could mean for the economy. Conventional thinking says that the market should continue to fall as the “bad news” is amplified. But that’s not completely true.
News happens one time. It is discounted once. If you own 100 shares of a stock and you wish to sell, you can sell your 100 shares only one time. The same is true on a larger scale. Unless there is new information, investors will discount a news item only once. Once the initial round of selling is over, you’re left with those who have decided to hold despite the information and those who sold due to the information. Until some new development changes minds, the event is in the rearview…
Expectations have a big impact on how news is received. Just imagine a company reporting earnings. Management could send out an optimistic release detailing how revenue grew 10% the previous quarter, with earnings clocking in at record highs.
But if investors were expecting 15% growth and even better earnings numbers, the stock would probably sell off. No matter how upbeat the news might be, the reaction to the event depends largely on the expectations of buyers and sellers.
The same is true of big events. If investors were expecting a big budget deal the night before a deadline — and the government delivered — the reaction would probably be muted at best. What was “supposed to happen” came true. So if there’s no big surprise, it’s unlikely that any opinions on the matter changed at all.
The unexpected moves markets. Expected outcomes are usually already priced in…
Greg Guenthner, CMT
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