You’ve had it happen to you. You want to buy a stock you’ve been studying for a while, and finally they announce a surprise bit of good news and the price rallies sharply higher and so you jump in, not to be left out.
You have a sudden profit on your hands but suddenly, the stock reverses. It has retraced back to your entry price. Wait – actually it has gone beyond your entry price and you’re now sitting on a loss! You decide that it’s just “market games” and “shaking out weak hands” and so you hold on, knowing that patience is a trading virtue. Eventually, you’re down further than you expected to be in the stock.
If you were ultra convinced of the upside potential, you may see this as an opportunity to buy more shares at a better price. Alternatively, you may panic and sell as you continue to watch the price trend further against you. What happened?!
Recall that the stock market is a rather efficient “discounting” mechanism that discounts all known (and some unknown) news. Academicians have even developed the “Efficient Market Hypothesis” which states that stock prices instantly discount all news so that there’s no possible way for an ‘at home’ trader to profit from news releases (or – they say – from trading in general). While I don’t plan on discussing that concept here, it pays to be aware that some scholars feel that strongly.
Trying to trade news can be an extremely perplexing and frustrating exercise for even the most logical person. Personally, I have been frustrated endlessly when I would hear a certain piece of market or stock-specific news and then become bewildered when the price traded violently in the opposite direction than the news indicated it should.
“XYZ reports profit 100% greater than last year – stock falls 8%”
“Today’s report showed less supply of oil than expected – oil prices and oil stocks fell hard today”
One reason this occurs is that those “in the know” anticipate conditions before they happen and further anticipate most news reports before they become public. It starts with the very informed insiders, then trickles out slowly until the ripples get to you when the financial media reports the story. By that time, those in the know (or those with good guesses about what’s likely to happen) have been accumulating shares quietly.
By the time of the actual news event, they use the interest (and excitement) driven by the public (which are often the last to know) to unload (sell) their shares which have risen in value, and are now spiking greatly due to increased demand. Once the people who heard the news that day have established their positions (many of which do so very quickly), there are fewer traders to push the market higher and overcome the supply that’s flooding the market.
As a perverse result, the price falls and traders who bought due to good news are confused why they are sitting on a loss.
Recall two key facts:
- News does not reach all market participants equally
- All participants do not interpret the news the same
As sad as it is, by the time the ‘at-home’ trader has heard the news on TV (unless it’s an “Act of God” or event that was impossible to foresee), it’s probably too late to profit in the direction the news might indicate.
In fact, if news is overwhelmingly good for the day, yet price reverses and closes on its low, then that’s usually a big signal of institutional distribution, and that prices could begin a downswing lower.
It’s much more of an art than a science, but do be careful next time a report comes out and you feel compelled to buy – wait to see how the price (and the market) reacts to the event, rather than acting on the news event itself.