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This week, the Fed, again, raised interest rates and, of course, that was big news for the markets. As I write this, the markets are trying to decide what to do with that news. Of course, the mere fact that interest rates were again increased is somewhat bearish, but insofar as the accompanying announcement hinted that there may at least be a pause in rate hikes, the news could be interpreted as bullish. Interest rates can be critical to the strength of the stock markets. The simple fact that an announcement regarding rates is going to be made may at least be enough to give the markets the jitters. News, some say, controls the markets. The funny thing is that it often seems the markets move in the opposite direction of what one would guess the news would suggest. Have you ever seen a company announce fairly decent earnings and the stock drops right away? Have you ever seen an announcement that a company just got a big contract and the stock drifts down? What's going on in those situations? Wouldn't it make sense that a stock should go up when it announces good earnings? Wouldn't you expect a stock to gain ground when the company announces that it just got a big sales contract? Why does just the opposite happen so often?

We've all heard the old adage: "Buy on the rumor, sell on the news." Often, that is what the professional traders are doing. As they know that news is coming, the professional may be a buyer on the expectation that the news will be good. For example, as the date on which a company is expected to announce earnings approaches, the stock price may move up on the expectation of that announcement. Sometimes, the move becomes steeper and steeper as the announcement date grows nearer. This movement is based on what? I contend it is excitement and expectation. The emotion propels the stock since the guess is that earnings will be strong. Buyers want to get on the bandwagon and as the price increases so does the excitement and more and more buyers join the action. Finally, the day of the earnings announcement arrives. What happens? Well, one scenario would be that the earnings fail to meet expectations. In that case, the stock often plummets. If the earnings meet expectations, is there any more reason to be excited? Probably not. The answer is now known and there is nothing left to anticipate; there is no longer a reason to be excited about what may happen so the price drops. Even when earnings beat expectations by a little, there is no longer a reason for anticipation and excitement. The news turned out to be simply that the earnings were "ok." In my view, those scenarios illustrate the logic of buying on the rumor and selling on the news. Actually, it seems to me that the better saying might be: "Buy on the rumor, sell before the news."

If we decide to wait to buy until news becomes public, we have no edge. The same news is available to everyone. Generally, the successful pros are already there and gone. So what do we do? One way to approach trading the news is to realize that volatility frequently increases as a known news event approaches. Suppose there is a takeover rumor. Often, that rumor, alone, will raise the price of a stock and lead to increased volatility. For option buyers, increased volatility is generally a positive. Increased volatility means increased option prices. If the option buyer buys at a low volatility and then there is a marked increase in volatility, option prices go up. One of the criteria used by some traders is to buy low volatility straddles. In other words, the option buyer knows that there will be some news announcement in the future (it could be an FDA decision on a drug approval or disapproval or an earnings announcement, or a rumored takeover, etc.) and the implied volatility of the options is relatively low. The trader could buy both puts and calls (at the money for a straddle) and try to make money on an increase in volatility, a sharp directional move in the stock, or both. If volatility increases rapidly and significantly, both the puts and the calls could increase in value. If we think about it, the straddle buyer is happy with increasing volatility. But we need to consider what happens when the announcement finally is made. When the news is out, the volatility generally collapses and the value of the options shrinks. Volatility traders who have purchased options generally want to be out before the volatility drops.

The stock trader should make himself aware of known announcement dates. Information on earnings announcements is readily available and normally can be obtained from your broker or from the brokerage web site. If we own a stock that is going up, it is probably a good idea to know when the earnings announcement is coming. If the stock price is moving up coming into the announcement, it doesn't mean we need to sell. It simply means that we may want to move our stop loss order up tighter or, at least, that we be aware that the stock price may drop on the announcement. After earnings are announced, it may be a good idea to watch a stock you like since a dip and later bounce could provide a great entry.

We know intuitively that news can be and often is quite important to stock and option trading. What many don't know is how to utilize the news. Buying stock on the release of good news may not work so well. Often, the news has been anticipated by the market before it is announced and the stock price reaction to the release might be just the opposite of what one might have thought. Fact is, the stock moved just as one would guess it should, but it moved before the news was released. Be aware, that there is often movement leading up to an expected news event. There is often a chance to jump on early in the move toward the announcement and the ability to jump off with a profit before the news is actually released. Remember that emotion plays a huge part in market movement. Anticipation and excitement can propel a nice run-up and actuality can stop the move because there is simply nothing left to be excited about or to anticipate.

News that comes out of the blue and is totally surprising can have significant influence on any portfolio. The immediate reaction to the attack on America on 9/11 is an example of such an event. When it became clear that the nation was being attacked, the markets dropped pretty dramatically and then the markets closed. When they reopened days later, the first direction was down. How do we protect against such unexpected events? One way, of course, is to pretend that no such thing will ever happen again. That is a pretty risky course of action. Another way is to hedge your portfolio. If you own stock you can buy protective puts, for example. If your stock drops radically and unexpectedly the put owner can force someone else to buy his stock at the strike price of the put he bought anytime before the put expires. Some traders hedge portfolios by purchasing puts on an index to attempt to maintain delta neutrality. The important things to remember is that you can use expected news announcements to your advantage and you can learn to hedge your investments against unexpected but newsworthy events.

As is almost always the case in my articles, I urge the reader to study and gain more and more knowledge as they progress in their trading. When any of us trade, we are putting our own money at risk. It is important that we gain as much knowledge as possible to learn how to reduce those risks, to learn how to effectively attempt to cut losses, and to try to learn how to let profits run without cutting them off prematurely.

Good Trading!
Bill Kraft

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