Wednesday, August 3, 2011

Buy the Rumor, Sell the News

Earlier today the United States Senate voted 76-24 to pass the bill that would raise the debt ceiling and cut the deficit. (I use the term "cut the deficit" loosely) It was considered fairly certain by pretty much everybody that this deal was going to pass because the fallout from it not passing would have been too much for our country to bear. So, why when the bill passed the senate at around 12:40pm did the stock market start inching down instead of flying up?
      The stock market is a fickle beast and at times it can be moved by different things. A market that is in a stable up trend tends to be moved by the underlying fundamentals of the different companies. Investors have a price that they are willing to pay for a certain amount of earnings in a certain investment sector (i.e. financial, tech, utility, etc.), and the investors buy or sell their stock based on information that becomes available (10K, 10Q, monthly sales reports). If the economy starts to go south the markets can become news driven. This brings volatility into the market for two reasons. First, until the news breaks people are left to wonder what is going to happen and how it will impact the economy/investment markets. Second, Even if they predict correctly what the news is going to bring there is no guarantee that the market is going to respond in a way that is commiserate with the news. This brings us to today's news.
      Going into the senate vote the Dow Jones Industrial Average was down about 100 points. It seemed reasonable to believe that we would get at least a small pop on the news that the bill received an up vote in the senate. (this would mean that we would not default on our obligations) As I sat there glued to the t.v (CNBC obviously) I waited for some news. Some call me cynical (I prefer realist) I was expecting the market to start moving in one direction before any news broke about the senate decision because there is always someone who is more connected than the little guy. All of a sudden the vote results flashed up on the screen and the market barely moved a pip. Then it happened. -110 became -112 which became -115 and -119. Our country had been saved and these ungrateful imbeciles were selling stocks. The reason is simple. When there is a binary event (yes/no) traders pile into either side of the decision. As a trader you are not looking for long term theories but short term profits. The traders who went long the market saw that even though they were right the market was not going to give them one stinkin' penny. At that point the decision was easy; sell off the position so you don't tie up the capital. We all know what happens when there are a lot of sellers and not too many buyers.
    So is there a moral to the story? Should we never trade binary events? The answer is no. Never is a very long time and it is just plan wrong in this scenario. Binary events can lead to huge profits as long as you have a strategy for exiting when you enter. Think about a building that has an entrance in one place but an exit in a completely different location. Now lets say you know that there is a 50 percent chance there will be a fire while you are in the building, but if you make it out of the building in one piece (whether there is a fire or not) you will receive a prize. What's the first thing that you would do upon entering the building? (and don't say not enter the building in the first place)
     Now let's extend the analogy a little further. Not only is there a 50% chance of the building catching on fire, but there is a 20% chance that when the building does not catch on fire it will flood. If you don't know where the exits are you pretty much have a death wish. For those who are analogically impaired... If your wrong without a stop loss or are right without a stop loss you are not going to have to worry about a stop loss in the future because you will have nothing to lose. Don't be a fool sell/buy stops are cool (a public service announcement from @SellStraddles)

Full Disclosure: I currently hold SPY puts, QQQ puts, Gold, and assorted small cap biotech companies.

1 comment:

  1. What happened yesterday to the financial markets was rather interesting, but upon taking a further a look, within reason. I think you need to evaluate the upside and downside potential of the debt ceiling deal. Throughout our history, we've raised the debt ceiling without a hiccup and financial markets didn't react to it. In this case here, the event had far greater downside potential than upside potential. Of course that downside would be a default.
    US Treasurys reacted by decreasing their yields - which as we know, moves inversely to pricing - and their prices (value) increased. Fundamentally, this is what should have happened as Treasurys’ perceived risk decreased; particularly the more price sensitive 30-year decreased several bps and the closely watched 10-year decreased a few bps. Another reason for the decrease was a global ‘flight to quality’ as investors snatched up U.S. Treasury yields and German Bunds sending yields lower for the day.
    Now as to why the equity markets took a dip. The financial markets have been in a downward slide in the past week from some rather meager economic data, which showed that the slow growth we had been witnessing regressed. Yesterday the market received its monthly report from the ISM (Institute for Supply Management) revealing a decline to 52.7% in July from 53.3% in June. Readings over 50% indicate more firms are expanding than contracting. The index is sharply lower compared to a recent peak of 59.7% in February.
    So let’s put this all together. Persistent weak economic indicators, paired with a drop in the ISM index, and the positive news having limited upside potential, traders cashed in where they could and contributed to the overall bearish sentiment. It should also be noted that some large banks such as Barclays and JP Morgan recently made downward revisions to their 2011 and 2012 GDP forecasts. This too could be factored into analysts’ models, as it seems that economy is cooling down. Another reason for the heavy selling volume is the expected weak job figures that will be released on Friday (8/5/2011).

    -Scott Roth