Trading the news: how markets react to new events

The news, what's happening right now, is as important to the investor as technical charts and historical market data. Company news, economic news, political news.

A successful trader cannot rely on the trends of the past to inform on future performance – look at any chart and it is periodically marked by large spikes that cannot be explained by the business cycle.

Events shape markets, and the successful trader must learn to navigate the potential pitfalls and accept the inevitable, occasional, news-based market slump.

News of the World

It helps, in this exercise, to categorise the news into two basic genres:

1. Recurring news: calendar items such as central bank interest rate decisions, economic data releases, quarterly corporate results and production reports.

2. One-off news: unexpected items such as major bankruptcies, terrorist attacks, surprise central bank announcements, violent geopolitical exchanges and government debt defaults.

Don't get caught out by the first category. Read your data calendar scrupulously and look for when the important reports are scheduled. Meanwhile, most stock exchanges publish a diary of the companies due to report quarterly earnings.

There's nothing you can do about the second. Just be on your toes when they happen. During times of market tension, don't leave an open position without a stop loss.

The bad news

Trading the news is not easy. We commonly think of two types: Good news, and bad news.

One-off news items, as mentioned in category 2 above, are rarely of the good news variety. Most news items of this sort cause markets to fall, sometimes tumultuously so.

Terrorist attacks come out of the blue, but most other types of one-off news have some kind of build up. Nations don't suddenly go to war without months, years, often decades, of posturing and sabre-rattling.

One-off news can cause markets to fall. Terrorist attacks come unexpectedly but other types of one-off news have some build up: Lenscap Photography/Shutterstock.com

Bankruptcies

Large companies rarely go bankrupt without warning: the collapse of Lehman Brothers in 2008 was presaged by a second-quarter loss of $2.8bn and an announced $6bn capital raising. Its shares lost 73% during the first half of 2008 and it didn't go belly up until mid September.

Between the end of June and September 16, Lehman had random days of gains based on the hope it would be saved, but by this time it was only the bravest day traders willing to back this hope. Its stock had already been eliminated from funds and all other major portfolios that might have added some stability to its price.

The bottom line here is keep reading the financial press, otherwise you might miss some of these important news items, then reach your trading screen and follow a 10% price pop in a company that's moments away from oblivion.

The good news

Some recurring news items can be good. A GDP report showing 3% annual growth; a US non-farm payrolls report showing 400,000 jobs created in January – both look great news on the surface.

All economic news, however, has to be traded through the lens of how markets interpret its impact on future interest rate decisions.

If an economy is emerging from many months, possibly even years, of recession or stagnation, then good news is good news.

If, however, this has been the third successive quarter of 3% growth, then the good news could be bad news for some markets – particularly for those sensitive to rising interest rates.

Analysts' estimates

Sometimes called consensus estimates. Reuters and Bloomberg (and sometimes other) news agencies poll economic analysts from banks and asset managers for their estimates of what the latest number in a data series will be.

An average is taken from all their estimates to arrive at the consensus estimate.

Similarly, equity analysts are polled on their estimates ahead of the release of corporate earnings reports.

These are all to give investors some idea of what the figure is likely to be. The analysts' estimate is useful as it is used by the market as a benchmark figure.

Equity analysts are polled on their estimates ahead of the release of corporate earnings reports: William Potter/Shutterstock.com

Here's an example of why you need to read all the economic and central bank reports and take note of the analysts' estimates:

Exercise:

You regularly trade the FTSE 100 index on a CFD trading platform, and occasionally also trade sterling against the dollar. The Office for National Statistics is due to report its "flash" estimate of UK third-quarter GDP in the morning and analysts' consensus estimate is for growth of 2.7%.

You know the following (all hypothetical) data:

• last quarter, the ONS reported 2.6% annual growth, up from 2.5% in the first quarter
• last week it was reported that monthly consumer price inflation (CPI) came in at 2.6%, up from 2.5% in the previous month
• at the last Bank of England interest rate-setting meeting seven of the nine committee members voted for a quarter-point rate rise, from 1.25% to 1.5%. The other two voted to keep the rate at 1.25%
• earlier this week, the latest labour market data showed the UK unemployment rate was down to 3.9% from 4% in the previous report

How do you position yourself for tomorrow's GDP report?

Growth is good news, but given all the other circumstances, equity markets could react negatively to further growth, as it could be a sign the economy is starting to get too warm.

If it's above the consensus estimate, the Bank of England may want to cool growth a little by lifting rates – seven out of nine on the committee already want to.

The trade

You might decide that you want to get as much of the move as possible, so ahead of the data release, set your FTSE trade to short (prices moving lower) the market, but put in the stops to ensure you limit your losses should the market go the other way.

Have an exit strategy too: even if the data show further strong growth, the initial downward momentum may not last all day. Markets could soon come around to the idea that they can firmly withstand a rise in rates.

Meanwhile, you might also set your sterling trade to go long (rising prices) against the dollar. Currencies love rising domestic interest rates. Higher rates make foreign investments in that country worth more and create more demand for its currency. Exercise similar caution with your stop loss option, however.

You might also set your sterling trade to go long (rising prices) against the dollar: RM911/Shutterstock.com

Trading corporate results

This is even harder to get right. There's a lot of data to absorb in a company's quarterly earnings report. Apart from the profit and loss account which shows revenues and earnings, there are likely to be sections showing debt, dividends and many other facets of its trading period.

Analysts are usually only polled on what they think the net profit before tax will be. Even if the results beat estimates, there's often something in the report the market does not like, and the stock will move lower in spite of the better than expected profit. This is also true the other way around.

Pay close attention to the proposed dividend – it is often a cut in payment to shareholders that disappoints the market, or a boost in the div that boosts the shares.

Conclusions

Make sure you have access to calendars and diaries – there are good weekly guides to be found on the internet that include the major data releases and show the previous number and the consensus estimate.

Keep up with financial news. Subscribe to a quality news source – the Financial Times, Wall St Journal, Bloomberg, Reuters etc.

Devise a strategy and stick to it – if the market goes the other way, you got it wrong. Don’t chase it.

Initial reactions may not persist for the whole day. Make careful use of stops.