How to Trade the News

The stock markets famously display a sustained upward trend over a long time period. But it’s the intermittent tailspins—like the 50% drop endured by most major markets during the 2008-09 global credit crisis—that test the fortitude of any investor.

The nimblest investors can make money no matter what is happening in the world. Trading the news should be an integral component of your investing strategy. While a day trader may trade the news several times in a session, a long-term investor might do so only occasionally.

Regardless of your investing horizon, learning to trade the news is an essential skill for astute portfolio management and long-term performance.

Classifying News

News can be broadly classified into two categories:

• Periodic or Recurring: This includes the scheduled releases of news that moves the markets, including interest rate announcements by the Federal Reserve, economic data releases, and quarterly earnings reports from companies.
• Unexpected or One-Time: These are bolts from the blue such as a terrorist attack, a sudden geopolitical flare-up, or the threat of debt default by an indebted nation. As a rule of thumb, unexpected news is more likely to be bad than good.

News can be specific to a particular stock or it can affect an entire industry or the markets as a whole.

Trading the News

Here are a few examples of possible actions that an investor could have taken in response to particular news events.

A Federal Reserve Announcement

The Federal Open Market Committee’s (FOMC) interest rate announcements have always been among the biggest market-moving events, but its announcement in mid-March 2020 was of unusual interest, not least because it was issued on a Sunday.

In an effort to ease the economic effects of the 2020 crisis, the Fed cut its main lending rate by 1%. It was the second cut of the month. It also announced plans to buy $700 billion in government securities.

The next day, the Dow Jones Industrial Average dropped 3,000 points in its worst day since the 1987 crash.

Many investors would have bet on a great day on Wall Street, and they would have been wrong. Other headlines dominated, including comments from then-President Donald Trump saying that the pandemic could last until August. (It turned out to be much worse than that.)

Nevertheless, investors who held on for just a few more weeks would have been amply rewarded when the markets started climbing again.

An investor in stocks who was looking to hedge potential downside risk could have done any of the following immediately after the Fed’s announcement:

• Trimmed positions in highly profitable equity positions to take some money off the table.
• Purchased puts either on specific stocks in the portfolio or on a broad market index like the S&P 500 or Nasdaq 100. Purchasing puts gives the investor the right to sell a stock for an agreed-upon price at some future time. If the security's market price falls below the agreed-upon price, the investor gains by selling at the higher contractual price.
• Bought a certain amount of inverse exchange-traded funds (ETFs) to protect portfolio gains. These move in the opposite direction of the broad market or a specific sector.

While these reactive moves would typically be carried out after the Fed announcement, a proactive investor could implement the same steps in advance of a scheduled Fed statement. This reactive or proactive approach to an important event or piece of news, of course, depends on a number of factors, such as whether the investor has a high degree of conviction about the market’s near-term direction. An individual's risk tolerance and trading approach (passive or active) also are factors.

A Jobs Report

In terms of economic data releases, few are more important than the U.S. jobs report because of its wider implications.

Traders and investors closely watch the employment level because it has a substantial influence on consumer confidence and spending, which accounts for 70% of the U.S. economy.

Jobs numbers that miss economists’ forecasts are generally interpreted as signs of incipient economic weakness, while payroll numbers that surge past forecasts are seen as a sign of strength.

In March 2021, the government announced that nonfarm payroll employment had increased by 916,000 the previous month, lowering the unemployment rate to 6%. Only about 210,000 new jobs were expected to be created. Crucially, many of the new jobs were in the travel industry, signaling a rebound. After a seesaw session, the Dow Jones Industrial Average closed up 171 points.

The investor playbook for trading jobs data is based on predictable market reactions.

• Payroll numbers below expectations: Implies that the Fed will be forced to keep interest rates low for an extended time period. The impact on specific asset classes could be predicted in this table:

• Payroll numbers above expectations: Implies that the Fed may scale back the pace of asset purchases, which could send bond yields and market interest rates higher. The likely result:

An investor could use these market reactions to formulate an appropriate trading strategy to implement either in advance of the jobs report or after its release.

A Corporate Earnings Report

If you invest in individual stocks, it is advisable to have a trading strategy in place in advance of an earnings report.

A stock's price can soar or tank in minutes after releasing numbers that impress or disappoint. Imagine having a huge short position in a stock and watching it soar 40% in the after-market because its earnings were much better than expected.

Trading an earnings report is by no means required. If you're in a stock for the long term, and you believe in its potential, you can ride out any quarterly storms. But if you have a fairly large position, long or short, in a stock, you need to weigh the merits of leaving it unchanged over the earnings report or making changes just before the report comes out. Factors that should play a part in this decision include:

• The current state of the overall market (bullish or bearish);
• Investor sentiment for the sector to which the stock belongs;
• The current level of short interest in the stock;
• Earnings expectations (too high or comfortably low);
• Valuations for the stock;
• Its recent and medium-term price performance;
• The earnings and outlook reported by its competitors.

For example, an investor with a 15% position in a big-cap technology stock that is trading at multi-year highs may decide to trim positions in it ahead of the earnings report, so that it now constitutes 10% of the portfolio. This may be preferable to taking the risk of a steep decline post-earnings if the stock is unable to meet investors’ high expectations.

An alternative option could be to buy puts to hedge downside risk. While this would enable the investor to leave the position unchanged at 15% of the portfolio, this hedging activity would incur a significant cost.

It may also make sense to trade an earnings report for a stock where the investor does not have a position but (rightly or wrongly) has a high degree of conviction.

Key points to note: Avoid taking an unduly large position, and have a risk mitigation strategy in place to cap losses if the trade does not work out.

A Bolt from the Blue

Not surprisingly, the 2020 crisis was a global event that threw stock exchanges around the world into a bear market that lasted from Feb. 20, 2020, until April 7, 2020.

Don't be concerned if you don't remember this. The stock markets then began a long upward trajectory and hit new record highs. The bull market that had begun after the 2007-2008 financial crisis resumed after a blip that lasted for less than two months.

This does not mean that bad news doesn't matter. But it does suggest that a knee-jerk reaction to sell everything and take to the hills may not be the best course of action. Over the years, financial markets have demonstrated resilience.

During times of geopolitical uncertainty, it may be prudent to rotate out of more speculative stocks and into higher-quality investments. You might also consider hedging downside risk using options and inverse ETFs.

While you should scale back your stock exposure if it is uncomfortably high, bear in mind that in most cases, short-term corrections caused by unexpected geopolitical or macroeconomic events have proved to be the quintessential long-term buying opportunities.

Tips for New News Traders

• Know the dates and times of important events: Information on the dates and times of key market events such as FOMC announcements, economic data releases, and earnings reports from key companies is readily available online. Know this calendar of events in advance.
• Have a strategy in place beforehand: You should plot your trading strategy in advance so that you are not forced into making rash decisions in the heat of the moment. Know your exact trading entry and exit points before the action begins.
• Avoid kneejerk reactions: Make rational investment decisions based on your risk tolerance and investment objectives. This may require you to be a contrarian on occasion, but as successful long-term investors will attest, this is the best approach for successful equity investing.
• Cap your risk levels: Avoid the temptation of trying to make a fast buck by taking a concentrated long or short position. What if the trade goes against you?
• Have the courage of your convictions: Assuming you’ve done your homework, consider adding to an existing position if the stock plunges to a level below its intrinsic value, or selling out to take profits in a stock that is wildly popular at the moment.
• See the big picture: Often, investor reaction to the news may not be as expected. You'd think an announcement of a dividend cut would lead to a sell-off in a stock. Sometimes, investors applaud the move as a signal that a company is investing more in its business.
• Don’t be swayed by market sentiment: Being overly swayed by market sentiment may tempt you to buy high—when euphoria runs rampant—and sell low when gloom and doom prevails. Consider the plight of the many hapless investors who were so spooked by the unrelenting tide of bad news in 2008 that they exited their equity positions near the lows, incurring massive losses in the process. They missed out on a stunning gain of 166% in the S&P 500 from March 2009 to October 2013.
• Know when to "fade" the news: Sometimes it is as important to ignore the news or “fade” it as it is to trade it. If you're in it for the long term, you can ignore the noise.

The Bottom Line

Trading the news is crucial for positioning your portfolio to take advantage of market moves and boost overall returns.