Trading Off of Catalysts
The timing of certain potential trading catalysts is known in advance. Examples include the release of periodic economic reports, elections, and certain presentations by politicians and policymakers. This allows traders the opportunity to position themselves in advance of the potential trading catalyst. It also provides more time for consensus expectations to form. And, it is the forecast error (the difference between consensus expectations and the actual results) that the market will respond to. One consequence of more precise consensus expectations is a smaller forecast error. In turn, this suggests a smaller market response for scheduled potential trading catalysts, other things equal, than for unscheduled potential trading catalysts.
Scheduled potential trading catalysts have another impact on trading activity, and that is to alter the timing of entry or exit of positions unrelated to a bet on the potential trading catalyst. For instance, the release of the monthly employment report by the U.S. Department of Labor often affects the bond, stock, and currency markets. A trader who wants to enter or exit some market might delay or accelerate doing so in order to avoid being stopped out from a position because of an adverse move caused by the release of a report that he does not have an opinion on.
In contrast, the timing of other potential trading catalysts may be unknown, but the outcome is fairly well-known. An example in this regard would be the invasion of Iraq during 2003. It was readily apparent to many observers that the Bush administration had already decided to invade Iraq months before it did. However, the timing of the action was uncertain to market participants. Another example would be the decision to end the 1:1 peg of the Argentine peso to the U.S. dollar. By late 2001 it was clear that the link would be broken; however, it was not clear as to when the peg would be ended.
The timing and content of many trading catalysts is unpredictable so that a trader cannot position herself in advance to take advantage of the perceived opportunity. Is it too late to profitably trade after a trading catalyst occurs? Not necessarily. Trading opportunities also exist after a trading catalyst occurs. Again, the nature and extent of the trading opportunities depend on the magnitude and duration of the market's reaction to a trading catalyst. In some cases, the market reaction may allow plenty of time to put a position on (albeit at less favorable prices than before the trading catalyst occurred). As noted earlier, a trader does not need a lot of time to put a position on or take a position off.
Not only is the timing or content of certain trading catalysts unpredictable but sometimes so is the market reaction. The Federal Reserve's cut in the targeted Fed funds rate illustrates the conventional view of the impact that a surprise central bank rate cut would have on equity prices. As will become apparent in this book, the market's reaction to trading catalysts is not always so predictable. As will be shown in the next chapter, market conditions and sentiment bias can influence the magnitude and duration of the market's response to a given trading catalyst. This adds a dimension of risk when trading off of scheduled economic reports and other potential trading catalysts whose timing is known in advance.
The opening example of a cut in the targeted Fed funds rate by the Federal Reserve illustrates a case where the price reaction is both relatively quick and large. Yet, as was noted, there is still time to put a position on. Sometimes, the reaction to a trading catalyst may not be as quick. Indeed, in some cases, the timing of the trading catalyst may not provoke an immediate reaction in market prices—that is, the reaction may be significantly delayed. Several examples of delayed reactions to events are discussed in the book. Delayed reactions create confusion over what the proper reaction to a trading catalyst should be but also create opportunities to put a position on.
In the January 3, 2001 Fed rate cut example, the impact on Nasdaq stock index futures prices grew as time passed during the first few minutes rather than declined in amplitude as time passed. This phenomenon is sometimes observed for trading catalysts that induce a delayed market reaction where the effect grows as time passes rather than diminishes. Another example in this regard is the reaction in the Indian stock market to news of the Congress' party's apparent victory in 2004. Yet another example is the reaction of Japanese markets to news of the Kobe earthquake in 1995. Both of these examples are discussed in more detail in Chapter 4, "Geopolitical Events," and Chapter 5, "Weather and Natural Disasters" respectively.
This book primarily focuses on trading catalysts that induce or seemingly induce large changes in prices. However, it also considers trading catalysts that may seemingly start a new trend in prices or reinforce an existing one. Basically, it is recognized that the impact of a trading catalyst may not be limited to a single trading day. Sometimes, there is a small reaction that accumulates into a large reaction over time. For instance, buying or selling frenzies or panics may extend and accelerate over time before climaxing. Most trend-following traders wait for the price action in the market to dictate when to enter or exit a position. The example that opens this chapter also illustrates a situation in which a positive short-term trend followed the Federal Reserve action.
Trading catalysts occur with great frequency. However, only a few induce large changes in prices immediately or cumulatively over time. Most daily changes in financial market prices are relatively small in percentage terms. Thus, large percentage price moves are of interest because they are both less common and because they tell us something about the process that generates changes in prices.
It would be wrong to think of traders as waiting for a trading catalyst to occur before responding to it by taking positions. To be sure, large price moves are often accompanied by large trading volumes. However, as explained in the next chapter, knowledge of market conditions and sentiment bias can create the conditions where the market can be subject to all manner of potential trading catalysts. Simply stated, a trader can react to a trading catalyst after it occurs or anticipate the market's reaction prior to the occurrence of the catalyst or catalysts and position herself accordingly.
Trading catalysts can affect the short-term liquidity of the market, as was shown by the dramatic impact the Fed rate cut had on the effective Nasdaq 100 stock index futures bid/ask spread on January 3, 2001. An increase in volatility may also be considered a trading catalyst by stimulating trading volume. It is also a factor that is internal to the market. Increased volatility leads to increased demand for vehicles to hedge the volatility. The additional trading may also create more short-term trading opportunities.
As will be discussed in more detail in later chapters, the market's reaction to a trading catalyst need not be consistent over time. Sometimes, the market focuses on one potential trading catalyst to the exclusion of other trading catalysts that might be announced at the same time. It seems that the market acts as if it has a one-track mind. Sometimes, it is not clear what the market really reacts to.
The price changes that trading catalysts induce are often transitory. This means that a trader seeking to position himself in advance of a potential trading catalyst will have to determine the appropriate time horizon for any prospective trade. Strong money management rules might keep a trader in a profitable position longer than the trader anticipated when he entered the trade. However, the trader is still subject to the risk of a sudden price reversal before the trader exits his position. For example, a trader who entered a buy order for the Nasdaq futures contract a few minutes late and was filled at 2650 on January 3, 2001 would find that he bought at the high of the day. All of this makes trading off of trading catalysts both difficult and risky.