"Ian, I’m really enjoying Options Trading Pit and have banked many gains with you so far, despite market conditions. Are there other ways to profit in this market? Thanks." – Jeff C.
Thanks for the question, Jeff.
There’s two points I’d like to make.
One is to continue following Options Trading Pit… as we’re expecting a host of new profit plays in the very near future.
The other is about finding small pockets of news-induced market strength, which we trade in Options Trading Pit and Small Cap Trading Pit.
Let me explain…
Use the News
For years, news trading was ignored. And that’s because of theories like Eugene Fama’s.
Eugene Fama’s 1973 Efficient Market Hypothesis, for example, says that when news is released, it is immediately reflected in the price of stocks.
In other words, he felt that markets efficiently and instantaneously process new information.
But he was wrong.
And I’ve proved that myself, having traded news for years. I’ve even written two research reports on news dissemination and ways in which news is used to change public opinion.
You see, what allows us to trade on news is information friction, or the delay in the dissemination of news to a greater number of investors through electronic media. Sometimes the news or rumor we pick up on won’t be fully disseminated, meaning the intended audience won’t get it until later in the day when they get home from work. By then, we’ve already bought the stock and are just waiting for the trigger (the nightly news report, for example) that’ll throw gasoline on our small flame.
By constantly monitoring the early-phase information sources, most of which are online, we learn the important news first and can make buy recommendations. That’s the first tier of trading on news.
As more investors learn of the news through dissemination, price and volume begin to soar depending on how good or bad the news is. This is the second tier of trading on news.
The third tier of trading news is the reaction to the reaction. By that night, you might hear of the story on CNBC or see it the next morning in the Wall Street Journal. And way down the line, the story may make the weekly magazines like Time, Newsweek, Business Week, or Forbes, piquing further interest and buy activity in the stock. This is the reaction to the reaction.
Why Eugene Fama Was and Is Still Wrong
Not all news is baked into the market and accounted for. I’ve disproved that theory countless times. I’ve taken my bumps and bruises discounting the efficient-market theory, but I disproved its validity, as did Evans and Lyon’s report in the Journal of International Money and Finance (2004):
"The market could still be absorbing or reacting to news releases hours, if not days, after they are released. The study found that the effect on returns generally occurs in the first or second day, but the impact does seem to linger until the fourth day."
Efficient market theory has also been disproved by the following studies:
"I examine returns to a subset of stocks after public news about them is released. I compare them to other stocks with similar monthly returns, but no identifiable public news. There is a major difference between return patterns for the two sets. I find evidence of post-news drift, which supports the idea that investors under-react to information [ . . . ] There is a large amount of evidence that stock prices are predictable."
—Wesley S. Chan, M.I.T., Stock Price Reaction to New and No-News: Drift and Reversal after Headlines
"Arguably, the most important process affecting price movements is the news arrival process. For example, in Ross (1989) the volatility of stock price changes is directly related to the rate of flow of information to the market [ . . . ] On days no news arrives, trading is slow and price movements are small. When new information arrives that results in a change in expectations, trading becomes vigorous and the price moves in response to the impact of the news [ . . . ] In addition to price movements, news arrivals can affect the time between trades, number of transactions, and volume of trade."
—John H. Maheu, University of Alberta, and Thomas H. McCurdy, University of Toronto, News Arrival, Jump Dynamics and Volatility Components for Individual Stock Returns
"Periods of good news are followed by periods of unusually high returns relative to natural benchmarks, with the reverse for bad news [ . . . ] Post-event drift is the tendency of individual stocks’ performances following major corporate news events to persist for long periods in the same direction as the return over a short window—usually one to three days—encompassing the news announcement itself."
—Andrew Jackson and Timothy Johnson, Unifying Under-reaction Anomalies
But the question remains, can the average investor really profit from news without having proprietary research?
As a study from the Harvard Institute of Economic Research observes, "New technology is rapidly democratizing securities markets. The costs of gathering information and executing trades are being driven to negligible levels. These changes allow a rapidly growing base of investors to participate in the financial system."
Take my 2004 play, IPIX, for example.
Fears of global and domestic terrorism dominated the headlines. The Department of Homeland Security was preparing to award $2.2 billion from the State Homeland Security Grant Program and $275 million from the Urban Area Security Initiative to state and local governments for community protection in coming weeks. And the FBI and DHS sent alerts to United States police agencies concerning alleged Summer terror plots against transportation systems.
And with IPIX’s announcement that its Command View 360, a video surveillance and security camera, could see in all directions with no blind spots, rumors that it could be a beneficiary of federal, local and state investments began. Needless to say, the buy recommendation was issued immediately.
And the profits just started to pour in. But don’t take our word for it.
Here’s what two readers had to say:
"…I was stopped out at $23.90 for a return of 300%."
"That is the quickest home run I ever experienced. In at $9.92, trailing stop got me out at $26.02."
And there are dozens of high-level studies to support my news-driven investment approach.
But let me take a step back…
Most of the time, there’s no big secret to the kind of news that makes a stock jump:
- Insider buying.
- Buybacks (repurchase agreements).
- Stock splits or dividends.
- Rumor or news.
- A big new product or major contract award.
- FDA approval for a new drug.
- Successful clinical trial for a drug candidate.
- The FCC granting a license.
- Big order from government.
- High-profile joint venture announcements.
- Commercialization of new technology.
- Spikes in volume, message board chatter.
- Senseless stock or sector sell offs.
- Bidding wars.
- Press releases circulated to shareholders or those on mailing lists.
- Press releases sent to major news providers such as Yahoo, SmartMoney, CNN, MSNBC, CNBC.
- Massive increases in volume and mentions in lists of best daily performers… and on and on.
The real beauty of trading on the news is the gradual spread of news from the few to the many. It simply proves that time lags can be exploited for profits.
Everybody knows stocks eventually go up following events like this. But average investors don’t move fast enough.
Sure, they’ll learn about it on the evening news or the next day in the newspapers… but by that time they’ve left money on the table. Fortunately, it’s quite easy for us to get in on the ground floor time and time again.
But please note, trading on news alone is a dangerous, highly volatile bloodsport. That’s the reason it’s not the sole trading apparatus in SC Trading Pit or Options Trading Pit.
Ian L. Cooper
P.S. Trading the news has helped score Options Trading Pit subscribers a robust 31 winning trades out of 37 tries, with the average winner returning an incredible 95.6%. Take a read of our new report to learn how to become part of "The 95% Club."