Trading On News---from AlphaTrends by Brian

No closing video today, I am out of town. Here is an excerpt from MY BOOK

You may be wondering what a chapter on news is doing in a book about technical analysis. A technical purist would take a closed-minded approach, indicating that “fundamentals don’t matter because the chart tells all.” Just as many fundamentally oriented managers express their perceived disdain for technical analysis (“Reading charts is like reading tea leaves.”).

The practical truth is that participants place their trades based on analysis of both fundamentals and technicals, and to completely ignore either is foolish. Don’t start thinking that I’m talking out of both sides of my mouth here – 95 percent of this book is dedicated to technical analysis, and the other five percent to this chapter. All of my timing decisions are based on price, not news or fundamentals.

Human nature is to ask questions. People want to know the “why” of those things they don’t understand right away. The markets are no different. All of us try to assign order to chaos, and crowd behavior in reaction to news frequently is very chaotic. We often do this instead of focusing on why a stock has already moved.

Personally, I want to know why people buy stocks in much more general terms. More importantly, though, I want to anticipate what their next move might be, when it may occur, how much risk to take and how much can I make if my analysis is correct.

In the market, the answer to why isn’t always easy to understand. Fortunately for traders, it doesn’t always matter. Interpreting news and committing capital based on our views of those events is very one- dimensional, just as monitoring the actions of just one participant is one-dimensional. But correctly interpreting human nature and crowd behavior is really what understanding technical analysis is all about. What causes one participant to buy or sell has very little significance beyond a couple of days.

It has been shown over and over again that no one is bigger than the markets -- remember Long Term Capital Management, Amaranth Partners, Bear Stearns and some of the other large “smart money” participants who went down in flames? If a very large participant attempts to move a stock – or even the market -- it can be accomplished for short periods of time, but it is very risky because it puts that institution in a large and likely difficult-to-liquidate position if the market moves against them quickly. Without proper risk controls in place, even the largest market participants can be forced out of business. Incidentally, many of the stocks you will trade successfully with a short-term timeframe are the recipient of a participant attempting to move prices in a particular direction.

Fundamentals Do Make Market Participants React
Fundamentals do matter because they are often the catalyst that causes a large group of participants to take buy or sell actions. There are many technical traders who buy breakouts or sell a stock short as it breaks below support. On a larger scale, there are more participants who buy and sell stocks based on their perceptions of a company or its products.

News releases are the biggest catalysts for participants to reevaluate their thinking about a company and make position adjustments based on expectations and ideas of value gained from the new information. News triggers emotion, and that emotion triggers actions that can be measured on price charts.

In college we are taught to evaluate a company based on its fundamentals, while technical study is given almost no attention. I learned a great deal in business school, but very little of it has helped me to become a good trader. What has helped me attain trading success with fundamental information is an understanding of when it makes sense to pay attention to these catalysts as it gives me insight into the psychology of the fundamental crowd.

I do believe that “the market knows all” and also that “news and surprises tend to follow the direction of the primary trend.” One of the principles of technical analysis is that the market discounts the past and anticipates the future. Whether it is anticipating where the economy will be in six to twelve months or the lifecycle of a business product, the smart money attempts to position its holdings to take advantage of emotional responders to the news when it is released. Financial analysis is big business, and institutions pay millions of dollars per year to access information based on in-depth analysis of what the future may hold for the economy, a market sector or an individual stock – and for good reason. It is the goal of an institution to accumulate shares before the “good news” is known to the majority of participants so they can be in a position to sell shares as price and volume expand.

When positive news is released, it is usually the public who buys from professionals. When negative news is released the coin flips, and professionals are often the buyers from the emotional public. The smart money buys temporary setbacks in a bull market and sells their long positions on short-term rallies in a bear market. It is common for strong markets to ignore negative news (“climb a wall of worry”), while weak markets react quickly and severely. Bear markets tend to ignore positive news and slide down a “slope of hope” or react with limited enthusiasm.

Today’s near-instant dissemination of information can be an undisciplined trader’s worst nightmare. Inexperienced and uneducated market participants -- the “dumb money” -- are more likely to be motivated by news headlines, chat room gossip, etc., and the market dutifully punishes their lack of thoughtful preparation with losses. Simply put, professionals anticipate while amateurs react.

===========================
As discussed, emotions are the enemy in trading, and it is easy to get caught up in the hype of a news story whether it appears to be bullish or bearish. Slowing down and introspectively answering questions about a news release can help keep you from making a knee-jerk reactionary buy or sell.

 Does it look like the information was “priced into the market” prior to the release? If the stock made a significant move in the days before the news report, there is a good chance that the move will fail, as the participants who anticipated the event will take advantage of news hype to liquidate their position and thereby extinguish the trend.

 Is it even news? There are times when smaller companies will “repackage” a news release in order to get more attention than the first time it was released. Small companies also will try to associate themselves with larger companies in an attempt to make their company appear more legitimate and stir up an emotional response from overly optimistic participants. Unfortunately for trusting buyers, news releases are sometimes used to generate public interest in a situation that may not be as optimistic as it appears.

 Is there a pattern to how the stock has acted when similar news was released? A good example of this would be quarterly earnings reports.

Answering these and similar questions allows you to slow your reaction to news headlines and think a situation through before deciding to commit your capital to a trade. You should be more interested in understanding the psychology of participants and what motivates them to buy or sell than knowing the fundamentals of a business.
================================

Once the news (for the economy or a stock) has been released, traders should be less interested in interpreting the news itself and focus more on how the market reacts to it. With that in hand, it’s easier to either ignore the news and focus solely on price action or find a low-risk way to exploit any subsequent movements.

Treat price reactions cautiously. Let the market first absorb the short-term emotional response, and then focus on the unfolding market action to determine if there will be a lasting impact that can be exploited in a low- risk manner. Some of the common actions following a news release are:

 The reaction can fizzle out (Figure 14.1), and the stock enters a period of inactivity (avoid these stocks).

 Significant news can create a new trending environment. If a stock breaks out of a longer-term consolidation after a news release, there is a high likelihood that the new trend will be able to sustain the move, particularly if the breakout is accompanied by a surge in trading volume. (Figure 14.2)

 When a stock is already in an established trend, news releases will often motivate enough participants to take action and accelerate an existing trend.

 Occasionally a true surprise catches a large group of participants off guard, and sentiment changes so drastically that the stock may reverse the prevailing trend.

Below are a few of the potential big catalysts of which you should always be aware.