May 23 turned out to be a shock to those who were expecting market circuits to be challenged! What started as a glorious rally, and with increased evidence that the ruling party actually did much better in its second poll, soon reversed all gains! So what happened.
The Old Adage Back and How!
There’s an old adage on the Street that says traders should “buy the rumor and sell the news”. It’s up there with “the trend is your friend” and “you won’t go broke taking a profit” in terms of being quoted.
Here’s how that idea works, and how traders can use it to stay ahead of earnings surprises that could be costly.
- Markets look forward: The first thing to understand about the stock market is it is forward-looking. The term “forward-looking” indicates one of the most crucial features of the stock market- its not the past performance but expectations that drive prices – Hence, news and rumors play a vital role in determining a stock’s current price as they are proxy to expectations. In this case, the exit polls created the opportunity much before the actual results for people to use it as a proxy. The consistency between most of the polls could have been a good reason to buy ahead of the actual results.
As markets move in anticipation of rumors, there may often be many reasons for the move to reverse once, the actual news is released. Basically, in simple terms, based on the rumors price reaches a new high before the event and falling lower immediately after the event because of profit booking (even when the news matches the forecast or in our case exceeded it).
- Expectations matter! The next idea to understand ahead of a potential catalyst such as an earnings report is that a stock’s reaction to the catalyst will be relative to the market’s expectations, not the actual news itself. For example, any investor with a basic understanding of business fundamentals knows that double-digit earnings growth is a sign of a strong company and a bright future. However, if a company reports 10 percent earnings growth when the market was expecting 15 percent growth, the stock will likely drop. It’s not that 10 percent earnings growth is a bad sign, it’s just that it didn’t live up to the growth number the market had already priced into the stock. As far as the polls were concerned, its possible that the results led to a far better picture which allowed the long positions to wait , and then to exit as the first sign of profit booking emerged dragging the markets.
Trading A Major Catalyst
Once traders understand how markets anticipate and react to major events, there are several common ways to trade them.
The first step in the adage is to buy the rumor – as momentum may start showing up with volumes. The smart money moves in ahead of the announcements and is very often leaving when other less experienced traders buy the announcement.
If a trader has a good idea that a company will deliver a strong earnings report, the time to buy the stock is well before its earnings date. Assuming the thesis is correct, other buyers will also likely be buying the stock ahead of the earnings date, driving the share price higher.
Ironically, traders who predict good news can often sell a stock for a large profit before the news even comes out as other traders pile into the stock.
This is probably what happened to the markets yesterday as well as domestic institutions may have participated in the selling to book profit.
After the big earnings number comes out, there could be a potential short selling opportunity when others are still buying.
When a stock has been steadily climbing higher for weeks ahead of a catalyst like an earnings report, it is a clear sign that market expectations are extremely high.
As a result, even good news will often be met with selling pressure and could drive the share price down.
Adages and Real Money!
This advice above is not for everyone – it’s basically a short-term trading strategy that is high-risk for those without an information edge or rapid skills in execution.
If you are more risk-averse than that, then not only can you safely ignore this market proverb, but you should also probably stay out of the markets around scheduled or likely event dates.
Of course, if you are a long-term, buy-and-hold investor, you can safely ignore all short-term price gyrations – and this post as well.
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