News Reversals
News
Reversals
From: Laurence A. Connors and Blake E. Hayward, Investment Secrets of a Hedge Fund Manager
(Irwin Professional
Publishing, Burr Ridge, IL, 1995), pp. 5-22.Â
Look before you leap
— Anonymous
One of our most exciting and profitable trading methods occurs when markets gap
higher on bullish news or gap lower on bad news and reverse. We call this
trading method news reversals, because it requires a major news event to
trigger a signal. This trading strategy is the epitome of exploiting the herd
mentality.
For example, let’s look at a hypothetical situation in the soybean market.
After the market closes, a crop report is released that shows a shortage of
soybeans, which is bullish for soybean prices. Analysts and experts then go out
and make very positive statements about the report. A buying frenzy is created
before the opening, causing prices to gap higher. This gap opening crates a
short-term overbought condition. Prices, instead of moving higher as expected,
begin moving lower. This selling begets further selling. Commercials come into
the market to lock into prices that are higher than yesterday. Short sellers
begin to smell blood and push prices even lower. The speculators who believed
prices could only go higher begin to panic. A full-blown sell-off occurs, and
prices head much lower. the trading strategy to exploit this scenario can make
an individual thousands of dollars very quickly.
Here are the rules:
Rule #1: Traders should wait for an extremely bullish or bearish event
to occur after the market has closed. For futures traders, this can be a crop
report, livestock report, economic report, weather report, and so on. Equity
traders should be looking at earnings reports, takeover rumors, brokerage house
recommendations, and so on.
Rule #2: The market must gap open above or below the previous day’s
high or low for a signal to occur.
Rule #3: On openings that gap higher, place a sell stop one tick below
the previous day’s high. On openings that gap lower, place a buy stop one tick
above the previous day’s low. Note: Equities cannot be purchased via buy stops.
The order must be done manually.
Rule #4: After you are filled, stops should be placed at the morning’s
opening price. As prices move in your favor, stops should be adjusted to lock
into profits.
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The following examples help illustrate why we find this trading strategy so
profitable.
Example #1.
This example if one of our favorites because it sets
itself up so perfectly.
On November 8, 1994, political history is made as the Republicans gain
control of both the Senate and the House of Representatives for the first time
in 40 years. The next morning, the dollar and bond markets surge on the news. A
buying panic for stocks is created before the opening. “Tax cuts….less
federal regulation…buy drug and defense stocks” is the rallying cry
before the opening. A news service quotes one market strategist as predicting
the Dow will open 25 points higher A few minutes later, another strategist is
quoted as predicting the Dow will open at least 35 points higher.
At 9:30 a.m. EST, the S&P 500 gaps open 4.65 points higher, and within
nine minutes the Dow Jones Industrial Average is up 38 points on enormous
volume. Half of our news reversal pattern has been set up. As happens so many
times, the market’s euphoria turns into doom. Instead of continuing its advance,
the market begins to sell off. A sell-short order is triggered at 468.70, one
tick below the previous day’s high. A buy-stop order for protection is placed at
the day’s opening price of 471.60. The market moves sideways for about an hour
before the next wave of selling hits. The S&P 50 finds itself down more than
8 points from the high made 2 1/2 hours earlier. The Dow, which had been up
almost 40 points is now down more than 20 points.
Depending on the trailing stop-order strategy one employs, a trader could net
over a $25,000 per contract profit in less than 90 minutes.
Example #2: The coffee market went through a major bull market in 1994
due to drought fears.
On Monday October 17, the December contract for the coffee market is called
to open 5-7 cents lower due to the rains that have occurred over the weekend.
Coffee in fact opens down 9.35 cents from Friday’s close and immediately
reverses. A buy stop is placed at 185.80, one tick above Friday’s low. At 11:40
ET, a news reversal buy signal is triggered. Immediately, a sell stop is placed
at 179.00 (the day’s opening). The market explodes upward 20 minutes later and
closes at 203.85 for a day trading profit of little more than $6,750 per
contract.
Example #3: Before the soybean market opens on October 20, 1994, the
National Weather Service reports that drier weather is expected. The drier
weather will allow farmers to resume harvesting their fields after a rain delay
earlier in the week. November Soybeans gap down to 539.60. A buy stop is placed
at 540.75 one tick above the previous day’s low, and is executed shortly
thereafter. Prices rally strongly and close at 549.50 for a 8 3/4 cents profit
for the day.
Example #4: On November 4, 1994, the stock market is called to open
higher due to a better-than-expected employment report.
The December contract of the S&P gaps open to 470.20, 140 points above
the previous day’s close. A sell stop is placed at 469.75, one tick below the
previous day’s high. After the euphoria of the report subsides, the market
reverses. The market continues to sell off and closes at 462.40, for a profit of
more than $3,500 per contract.
Example #5: After the close on October 12, 1994, the USDA reports that
Florida orange growers will harvest a much larger-than-expected crop than
projected. The next morning, January orange juice opens at 94.00, down one tick
above the previous day’s low. Almost immediately, the buy stop order is f9ileld,
and a protective sell stop is placed at the day’s opening price of 94.00. The
market drifts higher for the next couple of hours and then explodes to as high
as 99.8=75 before settling at 99.25 for a day trading profit of 4.90 cents.
The following three news reversal examples are from the equity markets.
Example #6: Before the opening, on January 26, 1994, Clark Equipment,
one of the largest construction machinery companies in the world, announces
earnings below Wall Street’s expectations. It takes the specialist almost 45
minutes to open the stock due to an imbalance of sell orders. The stock finally
opens, down 1 1/8 to 50 1/4, and immediately reverses. A news reversal buy order
is triggered at 51 3/8, 1/8 above the previous day’s low of 51 1/4. At this
point, those who had sold on the opening at 50 1/4 are feeling foolish, and the
short sellers are feeling the pain. The stock continues to rise throughout the
day and closes at 52 3/8, up 1 1/8 fro the previous day’s close. Over the next
few days, the stock continues to rally and three days later closes at 58 /38,
seven points higher than the entry point.
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Example #7: On October 8, 1993, Hoechst Celanese announces they are
buying a 51 percent stake in Copley Pharmaceutical, a company whose stock price
has tripled over the past 12 months. On Monday morning, October 11, Copley’s
stock opens at 53, 3 1/4 points above Friday’s close. The market reverses and a
short sale is made at 49 7/8 (1/8 below Friday’s high of 50).
The short position will be covered at 53 (the day’s opening) if we are wrong.
The market continues to sell off, though, and closes at 46 for a day trading
profit of 3 7/8 points.
The long-term sell off is more dramatic. After our news-reversal pattern, the
stock loses an additional 24 points over the next four months.
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Example #8: After the market closes on September 14, 1994, Federal
Express announces earnings that far exceed Wall Street’s expectations. The next
morning, before the opening, a number of brokerage houses either raise their
opinions or raise their earnings estimates for the company. After a 30-minute
delay caused by an onslaught of buy orders, Federal Express opens 7/8 of a point
higher than the previous day’s high. A sell short stop is placed at 70 1/8, 1/8
of a point (one tick) below the previous day’s high. The stock proceeds to trade
as high as 72 1/8 and reverses, closing the day at 67 3/4, down 2 1/2 points for
the day. The Sell-off in Federal Express continues over the next three days,
pushing the stock down an additional 7 3/4 points.
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Summary
As you can see, news reversals can be a very profitable trading strategy.
Obviously, not all gaps caused by news reverse themselves. However, when
reversals do occur, the probability of them being profitable is high.
We have selected examples from the futures market over a five-week period
that was very profitable. On the whole, our research has shown that news
reversals, when traded correctly, can be profitable approximately 70% of the
time. Because the potential impact of each news story is subjective, the results
will vary slightly from trader to trader. Aggressive traders will take all news
stories as a reason to trade this strategy. Conservative traders will be more
patient and only trade those news stories they believe are significant.
The most important lesson of this chapter is this: If it doesn’t go up on
good news, it is going down; and if it doesn’t go down on bad news, it is going
up. News reversals prove it.
From: Laurence A. Connors and Blake E. Hayward, Investment Secrets of a Hedge Fund Manager
(Irwin Professional
Publishing, Burr Ridge, IL, 1995), pp. 5-22.