Session 22 (of 42): Information Trading - Trade on the News

0:00 Hi, welcome back. In this session I'd like to talk about trading on information, buying or selling based on information. Wall Street is full of these little adages, buy on the rumor, sell on the news. Is that true? So to set the foundation for what we're going to do in this session, let's think about what information is and how this process plays out. When you track a stock in the market, you have investors holding the stock and new information comes out about the stock. It could be an earnings report, a rumor about a stock, a management change.

0:35 Investors attempt to assess the effect on price {slash} value based on that information. Now that assessment can be different for different investors. Why? Because the information they receive can actually be different. That might not be the case with an earnings report, but it could be the case with a rumor. And the way they process that same information, a thousand investors can look at the same earnings report and come to a thousand different conclusions about that. The ultimate price change will depend on demand and supply.

1:05 It's a messy process, right? Information comes in, investors try to reassess, sometimes they get it right, sometimes they get it wrong. So let's think broadly about the different ways in which information play out in the market. If you live in a truly efficient market, should prices change? Yes, when new information comes out, but they should change instantaneously. So that's if If you get new good news about a stock or a company, the stock price should pop up to reflect that good news, but then it should level off.

1:39 So in an efficient market, there will be price changes, but they will be instantaneous as the information is revealed. If you have a slow learning market, here's what will happen. Information comes out, it's still good news. Investors push up the price a little, but they're not quite done. Other investors take more time. So, over time the price will drift up to what it should be. How long that drift last can vary depending on how efficient the market is. It could be in 5 minutes, 10 minutes, or it could take 5 days to do this.

2:11 That's a slow learning market. What if you have an overreacting market? The good news comes out, the price pops, but it pops up too much. It goes up too much. And because it goes up too much in the days or the hours or the minutes after the price will drift down. The keyword is drift. In an efficient market, there should be no price drift. In a market that's not quite efficient in assessing information, there can be price drifts up if it's a slow learning market or price drifts down if it's an overreacting market on good news, and the reverse is going to be true on bad news.

2:47 So, if you want to trade on information, you need to start by making a judgment on which of these three views of the world you adopt when it comes to information. Cuz there are broadly three strategies you can use for trading on information. The first is you can trade ahead of the news. If you can pull this off, this has the biggest upside. What does this mean? Before an earnings report comes out, you start buying companies where you think the earnings announcement is going to contain good news. How do you know that?

3:17 You do research. You come up with your own way of doing it. We'll talk about different ways you might get that assessment. But you buy it before And when the earnings report comes out, assuming you were right and the earnings report is good news, you get the jump in the price, trading ahead of the news. You can trade on the news. The earnings report comes out, you buy the stock instantaneously if it's good news, hoping to take advantage of it. Or you sell the short stock in And which one you do will depend on whether you think, you know, the the effect is going to be, you know, is is fully played out or whether there's going to be a drift.

3:52 And you could even do this on volatility changing. Or you could trade after the news. Yeah. What does that mean? You wait a day after the earnings report and you try to take advantage of that continuing drift in either direction. Buying or selling on that drift. You can trade ahead of the news, on the news, or after the news. Let's take a look at each of those different types of information trading strategies. First, ahead of the news.

4:19 How do you make an assessment that that news report that's not due to come out a week from now is going to contain good news or bad news? There's one way, which is probably illegal in the US and in much of the world, which is you have inside information. And let's face it. I know I'm cynical on this. Insider information exists. People trade on it. There's going to be a drift ahead of good news or bad news. Insider or private information.

4:47 The second is rumor mills. There's rumors all the time about companies. The problem is most of them are false, but perhaps you have a good a source of good rumors. Rumors that actually have basis. That might be a way. Or you could do research. Maybe you come up with a way of forecasting which types of companies are going to report good earnings. Insider information, rumor, or research. Now, how you trade on this will depend on how reliable that in- that news source is, right? To the extent that you're trading on a rumor and the rumor is very speculative, you got to hold back a lot more than if you're trading on inside information that is guaranteed.

5:28 And your investment strategy will also depend on on not only will it when you trade depend, but how much you trade and how big the trade can be will also depend on the reliability of the strategy. So, those are the things that you can use to trade ahead of the news. What about on the news? You can trade on the immediate price reaction. Good news comes out about a company, the price jumps, you might decide the price jump was too much and you sell the stock. Or the price jump was too little and you buy the stock. You're taking advantage of the drift that's going to come if you're right after the announcement.

6:04 But you can also trade on volatility. You think, "What does that mean?" Over the last 40 years, there have been instruments that have been created that are less about the level of the price and more proxies for volatility. In the In the overall market, this can take the form of the VIX. The VIX is actually an index on equity market volatility. And what you're trading on is that the level of volatility itself might change over time.

6:31 So, news comes out, it can affect not just the the price level, but the volatility in the stock. The stock could get riskier or safer. And you're making an assessment in whether the volatility that the market is building in is just right. So, let's take an example. Let's suppose an earnings report comes out that reveals that this company is entering riskier businesses. Well, that's going to increase the volatility in the company, right? You go to the market and option prices have gone up to reflect, but they've gone up too much. In other words, the market has overestimated how much volatility should change and you're trading on that volatility.

7:10 So, whether it's using options or direct instruments on volatility, you're trying to take advantage of shifts in volatility that you think are either too low or too high given the information. So, in addition to trading on the level of the price, you're trading on the volatility in the price. That's on the news. What about afterwards? There, the judgment that you made about whether markets are slow to learn or overreacting come into play. If it's a slow learning market, here's what you're going to do. You're going to buy after good news. You're going to sell after bad news. You see why, right? Cuz you buy after good news, the drift continues to be positive, you make money on it.

7:46 You sell after bad news, it's a drift down on which you make money as well. If you have an overreacting market, you reverse the strategy. You sell after good news because you think markets overreact, there'll be a drift down, and you buy after bad news. In both cases, not only do you have need to get the timing of when you buy or sell right, you got to get the timing of when you exit your strategy also right, but So, you can trade on the news, you can trade before the news, you can trade after the news. Now, all of this, execution becomes a much more critical part of your strategy. Unlike traditional value or growth investing where we did not talk much about execution, when you have an information-based strategy, it matters when you trade and how quickly you trade and how low your and how low or high your transactions costs are. So, you have to make judgments about the execution part.

8:43 And the transactions costs will come with that strategy. With an information trading strategy, if you're not careful, you might make money before transactions costs, but very quickly wipe them out with your trading costs. And if your information is coming from that gray area between inside information that's illegal and private information that's legal, you got to make sure you're on the right side of the line. Cuz that's a different kind of risk, a risk you might end up in jail cuz you used information you shouldn't have used to trade.

9:15 So, let's summarize. An information event is a news story either about the company, the market, the sector that can move prices. In information-based trading strategies, you start with the presumption that markets don't always react the right way, right way in terms of adjusting prices to information, and you're going to try to exploit those mistakes to make money for yourself. Now having said all of that this session has been pretty abstract because we haven't actually defined individual information events. In the next few sessions we're going to talk about earnings reports, insider trading filings, you know, the acquisition announcements, management changes, the kinds of news stories that hit markets and look at what the evidence shows about about how well or badly markets do in responding to those new that news.

10:06 Thank you very much for listening.