By Chris Ebert

Note to readers: the following weekly analysis is based upon findings in the Thursday Evening Options Brief

Who among us wakes up in the morning, sees horrible news or terrible economic data, and immediately says “I want to buy stocks today”?

bad newsLikely, very few traders see fundamental economic weakness as the sole reason to buy stocks. In fact, most rational people would prefer to sell stocks given poor news regarding corporate earnings, employment, sales, prices, or any other factor which would tend to lower the chances of future corporate profits.

Nevertheless, sometimes bad news is good for stock prices. This can occur for a variety of reasons:

  • Traders were expecting worse news than what actually took place and thus more prone to buy stocks while feeling a sense of relief.
  • Other economic forces (e.g. the Federal Reserve) might be prepared to act in a manner intended counteract the effect of bad news, so the net effect of bad news could be good for the economy and thus perceived as good for future stock prices.
  • Long-term traders were looking to buy on a dip, and a dip is what was created when the news initially pushed short-term traders to sell, followed by higher prices when long-term traders stepped in.
  • Market-movers were seeking to use bad news as an opportunity to create a Bull trap, temporarily confusing other traders into buying stocks so the market-movers themselves could unload their stock positions to willing buyers at a much higher price than those buyers would otherwise be inclined to pay when confronted with poor economic news.

The Devil is in the Details

Of the above scenarios, the actions of market-movers – large collectives of investors and institutions – are capable of pushing stock prices in a way that is often not intuitive.

Any trader can intuitively understand an occasional “buy-the-news” event, even if such an event comes as a surprise. XYZ stock goes up after some bad news is released and nobody seems to know why, until it becomes obvious that some large group of traders was expecting the bad news and were merely relieved once the bad news was publicly revealed. Once the news is public it is no longer open for speculation. The devil you know is better than the devil you don’t.greenspan

Most traders can understand how the actions of large entities such as central banks can send stocks higher on a bad news day. Even traders who disagree with the policies of these large entities must often capitulate when it becomes obvious that the entity’s actions are more important to the market than the bad news. The Greenspan Put and the Bernanke Put are each  a textbook example of widespread manipulation that can lead to stock prices increasing in the face of bad economic news. Since bad news tends to spark intervention,m and intervention is often intended to boost stock prices, bad news can sometimes be good for stocks. If A = B and B = C then A = C.

Traders also tend to comprehend the importance that different time frames can have regarding reactions to news. Two traders can buy the same stock at the same time. One will make money and the other will lose. It depends how long each holds the stock and their willingness and ability to hold it through periods of decline. Short-term traders often cannot hang around when bad news sends prices down, even temporarily; and long-term traders use such buy-the-dip opportunities to drive prices higher. Bad news can certainly send stock prices higher if it is perceived to have little or no effect on long-term prospects for profits, especially once the weaker short-term traders have been shaken out of their positions. Short-term and long-term traders each learn to accept the effects of each other’s differing time frames; it’s perfectly understandable.

The thing that can really, truly drive a trader insane is the effect market-movers can have when the market reacts to news. Big money interests seem to toy with traders’ minds as if it’s all a childish game – only it’s generally not a game to most individuals; to most, it’s a matter of survival; one too many losses can spell the end one’s survival as a trader.

Market-mover’s actions are often not outwardly intuitive, and not understanding those actions can lead to harm both emotionally  and financially. Individual traders may give up, either out of frustration or because of excessive losses if they do not account for the effects of market-movers. Perhaps the most common such effect is an increase in stock prices that accompanies bad news.

It’s a Game to Some

To large institutional interests, the ability to move the market at will is a huge advantage in survival. Essentially, most such interests don’t need to worry about losing so much capital that they can’t survive. While it is true that some rather large ones have failed at times (e.g. Lehman Brothers) most are sufficiently large to be able to withstand some significant temporary financial setbacks.

chessThe ability to suffer setbacks and to recover is what promotes survival for institutional traders and individuals alike. What sets the large institutional interests apart is that they can use their ability to suffer a setback to their advantage. In other words, large institutions can flood the market with cheap stock when it suits them, much as a large retailer can flood its respective market with cheap merchandise to drive out weaker mom-and-pop competition. Individual traders normally do not possess such ability.

Even if large institutions suffer some losses in the process of flooding the market with shares of stock for sale, the ability to drive stock prices lower is an enormous advantage. It forces some individual traders to abandon their positions, either consciously closing them because of poor performance or unconsciously through the tripping of stop-loss orders. The institutions then buy shares when they reach bargain prices.

Since market-movers have the ability to move stock prices in either direction, up or down, it makes sense that these large institutions will not only drive stock prices down when they want to buy, they will also drive stock prices higher when they have a desire to sell.

When would you have a desire to sell if you were a market-moving institution?

It is understandable that bad news would give institutions a reason to sell, just like it would tend to give the individual retail trader a reason. The only difference between the institution and the individual is the action taken after receiving bad economic news. The individual is prone to sell, especially if the news results in falling stock prices (since the individual does not have the ability to move the market). The institution is prone to buy, in order to force stock prices higher (because it can move the market and because it wants to sell at high prices).

5 Easy Signs of Bull-Market Traps

The quandary for an individual trader is that the effect of bad news can be deceiving. If a trader looks to the reaction to the news as a guide, it is possible for the trader to step into the market-mover’s trap. If a trader ignores the market’s reaction and sells stocks every time there is bad news, regardless of the reaction, many opportunities for profit will be missed, and some unnecessary losses will likely occur.

A particularly devious tactic by influential participants in the stock market is to set traps. When good news hits, these participants sell large quantities of stocks – more than the market can absorb – in a short amount of time. This drives stock prices temporarily lower, at which point the same participants then step in to buy the same stocks they sold earlier. When bad news hits, they do the opposite. They buy stocks to set a trap, temporarily sending prices higher, and then they sell or short the same stocks they purchased, sending stocks plummeting.trap

Individual traders can easily fall into a trap – it happens to just about everyone from time to time. The reason it’s so easy to be trapped is that it’s often difficult or impossible to spot a trap in advance. Only in hindsight can one know if a trade set-up was indeed a trap. Even so, it’s better to realize late than never.

Traders get trapped all the time. The ones that learn to free themselves quickly are the ones that survive the best. But, in order to free oneself a trader must first learn to recognize that it is a trap.

Obviously a good institutional trader may make attempts to camouflage its traps. Nevertheless, it makes sense for the individual to consider the market’s reaction to bad news. If there are any clues to a trap being laid, they are likely to be found in the market’s reaction.

  1. Was the market expecting bad news?
    It is unlikely for folks to wake up in the morning to shocking economic news and suddenly find a desire to buy stocks. A surge in prices after an unexpected bad-news event is evidence of a trap, not conclusive evidence, but still evidence. Expected bad news events, such as earnings or employment numbers are less suspicious.
  2. Are enormous economic entities (central banks) engaged in policies that could turn bad news into good news?
    This question is a difficult one, as monetary policies all over the world have become more dedicated to the task of making bad news good in recent years. Still, it doesn’t hurt to question whether an increase in stock prices makes more sense as a result of a monetary policy expectations or more sense as a trap designed to look like the result of such policy. Just because media reports attribute something to monetary policy doesn’t necessarily make it so.
  3. Is the long-term trend so entrenched that long-term traders would welcome a sell-off on bad news, if for no other reason than to buy more stocks at lower prices?
    If it’s been a while since the last major Bull-market correction, chances are good that many folks would welcome a dip in stock prices. Thus an increase in prices that flies in the face of bad news should always be suspect when a price-correction is overdue. Bad news is intuitively a perfect excuse for a price correction, thus a rally on bad news can be a sign of ulterior motives.
  4. Did the increase in stock prices make technical sense?
    Stock prices that zoom higher when a chart pattern would suggest a rally is improbable should always be suspected as possible traps. It doesn’t necessarily mean every stock that violates a widely-used technical pattern is being manipulated by market-movers, but it’s worth considering if such a move could be a trap. It takes a certain amount of skill to spot a bearish pattern developing, thus an equal or greater amount of skill is required to set a trap for followers of the pattern. A rally on bad news, particularly one that violates a chart pattern can be a work of art deserving of respect.
  5. Is trading volume appropriate?
    Stock prices tend to rise because of an increase in demand. But, they can also increase due to a lack of supply. It is important to consider whether stock prices that rise in the face of bad news are being driven higher by higher demand or by lower supply. Lower-than-normal trading volume can be a clue that widespread buying is not taking place on a bad news day. Perhaps most of the volume is due to market-movers filling only the sell orders of individual fundamental traders spooked by the bad news, while technical traders patiently sit on their shares and are content to hold as long as prices are steady or rising. Low volume on a bad news day can sometimes be a sign of a trap.

In the past week or so, stock prices have made some large moves compared to the relatively quiet trading of much of the year. The Dow made several triple digit moves, including a 300-point loss.

The S&P fell nearly 30 points in a single day on March 6 on seemingly good news – U.S. job growth. It then rose more than 20 points on March 11 even as a major market component, Intel, reported low demand, and also as oil prices, which have been blamed for recent market declines, continued lower. Was the rally on March 11 a trap? Or, was it just the result of increased volatility?

Certainly an increase in daily volatility and daily range is to be expected when the S&P 500 nears the Line of Violence. As shown in orange on the chart below, the Line of Violence tends to be one of the most unsustainable levels for the S&P. Stock prices normally move wildly when the S&P is near or on the Line, as it was this past week. Maybe that explains the sell-off on a good news day and the rally on a bad news day; Maybe. Or, maybe it’s a sign of a trap.

OMS 03-14-15c

If it’s a trap, it likely won’t be known that it was a trap until it snaps shut. Until then, the best an individual trader can do is stay vigilant – consider the warning signs of market traps. After all, it’s still a Bull market. The options say we are now in “correction” territory, but it’s not yet a Bear market.

As long as it’s a Bull market, rallies are possible, even rallies to new highs. But rallies that occur on a bad news day are never normal, even in a Bull market, no matter how commonly they occur. They are always important to ponder. Nobody wakes up on a bad news day and immediately says “I want to buy stocks today”. They just don’t.

The preceding is a post by Christopher Ebert, Chief Options Strategist at Astrology Traders (which offers subscribers unique stock-trading perspectives and options education) and co-author of the popular option trading book “Show Me Your Options!” Chris uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. Questions about constructing a specific option trade, or option trading in general, may be entered in the comment section below, or emailed to OptionScientist@zentrader.ca

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Related Options Posts:

Thursday Evening Options Brief 12-Mar 2015

S&P 500 Now Entering Violent Neighborhood

Do Meteorologists Make Good Stock Traders?

 

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