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Analyzing the Market Reaction

The financial market reaction to the Federal Reserve announcement is both fascinating and puzzling. It illustrates the powerful impact that a trading catalyst can exert on financial market prices. To be sure, the size of the market's reaction was likely exacerbated by the expectation that this rate cut would be the first in a series of rate cuts by the Federal Reserve and by the fact that the announcement came as a surprise to most market participants. The reaction may also have been exacerbated by the fact that the Nasdaq Composite plunged 7.23% the day before. However, the size of the reaction in the Nasdaq spot and futures markets was enormous. And, other potential trading catalysts were not readily apparent.

The market's reaction to the announcement also raises some disturbing questions. Was the reaction of Nasdaq stocks and futures a case of euphoria or a logical response to the arrival of new information? Why did the Dow Jones Industrial Average and the Nasdaq spot and futures markets react so differently in magnitude to the same piece of news? Why did the Nasdaq futures market apparently overreact to the Fed announcement? Was the reaction of market prices to the catalyst alone or did the market feed on itself? What role did the electronically traded Nasdaq e-mini futures contract play in impounding the news of the rate cut?

The behavior of financial market prices in response to trading catalysts is of keen interest to traders, investors, and policymakers alike. Traders are less interested in whether the response of market prices to a particular trading catalyst accords with what financial economic theory would predict than with how the response impacts their trading opportunities and affects their trading strategies.

Traders have a different, but related, set of questions to answer when an unexpected trading catalyst occurs.

  1. Which market or markets are most likely to be affected? The answer to this question depends on the prevailing trading thesis (i.e., the perceived relationships between the catalyst and financial market prices). The belief that an unexpected increase in employment would cause the overall bond market to tumble is an example of a trading thesis.
  2. What is the likely direction of the price move? (The answer to this question depends, in turn, on what market consensus expectations, if any, were before the catalyst occurred.) For instance, many participants believe that a larger than expected increase in employment would cause bond prices to fall, whereas a smaller than expected increase in employment would cause bond prices to rise.
  3. What is the likely magnitude of the price move?
  4. What is the likely speed of response of market prices to the catalyst? Although many academics would regard a market reaction lasting several minutes as exceedingly quick, most traders would not. A minute can be a lifetime in the world of trading. A few seconds is often more than enough time to enter, exit, or even reverse a position. The relevant question is do you have enough time to execute a trade?12
  5. What is the likely duration or half-life of the trading catalyst's effect on market prices?
  6. Will the price move intensify or deteriorate as time passes?
  7. Will prices overshoot?

Given the answers to the preceding questions, the trader must then determine the size of the position to put on. The more uncertain the answers to these questions, other things equal, the smaller the position size the trader will put on.

Many traders think in terms of what might be called event time—that is, the market's reaction to similar events in the past is used as a guide to how the market will likely respond to similar events in the future.13 Thus, a trader's prediction of how the market will react to a second U.S.-led war against Saddam Hussein's Iraq is influenced by how the market reacted to the first such war. Although such an approach is understandable, the market need not be consistent in its response to similar trading catalysts over time. The principal problem with the use of event time to forecast market reactions to trading catalysts is that it inevitably entails the use of a small number of observations from which valid statistical inferences cannot be drawn. This drawback is unlikely to stop many traders from using event time. Another problem with using event time as a predictor of how the market will respond to a trading catalyst is that the timing of the impact might be off as more traders attempt to exploit the same perceived relationship. Sometimes in the rush to simplify the analysis to use event time as a guide for trading decisions, traders miss potential offsetting factors that make the analogy inexact.

Notice that the impact of the Fed rate cut announcement was not limited to affecting the level of market prices alone. Rather, the Fed announcement affected both the bid/offer spread (as noted previously) and the volatility of financial market prices. This illustrates two other ways that some trading catalysts (particularly those whose timing can be anticipated) influence trading decisions. In this way, scheduled or anticipated trading catalysts facilitate bets on changes in volatility. Finally, the volume of trading often rises sharply after a trading catalyst occurs.

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