Trading News Gaps: Should You React or Step Back?
You may have noticed that prices often gap up or down when news is released overnight or just before the market opens.
Some news comes entirely out of the blue -it’s unpredictable and unavoidable unless you close all your positions at the end of each day, like a disciplined day trader. On the other hand, certain events are more predictable. For example, companies often announce trading updates at well-publicized times. If you know that a company is set to release results tomorrow morning, it might be wise to avoid holding a long or short position in that stock until the news has been absorbed into the price, usually within the first hour or so of trading.
The Risk of Holding Through News
Of course, if you keep a spread bet open on a stock prior to its trading update and the price reacts in your favor, you’ll look like a hero compared to someone who played it safe by closing their position early. But there are two major risks to this bold approach:
- Uncertainty of the Outcome
Unless you have inside information (which is illegal to act on), you won’t know whether the news will be positive or negative until it’s released. - Unpredictable Market Reaction
Good news doesn’t always lead to higher prices, and bad news doesn’t always push prices lower.
Why News Reaction Is Unpredictable
As a retail trader, you should assume that institutional traders will receive and react to news faster than you. By the time you process the announcement, the price may already have dropped (in the case of bad news) or risen (in the case of good news). Worse, the price could quickly reverse direction after your delayed entry.
Further complicating matters, the market’s interpretation of news isn’t always straightforward. For instance:
- Bad news might not cause the price to drop if it’s less severe than analysts predicted.
- Conversely, good news might result in a price decline if it fails to meet lofty expectations.
I once read an author’s witty critique of analysts’ forecasts, which questioned the logic of punishing companies for missing projections. Isn’t it the analysts, with their flawed predictions, who are “wrong”? After all, the company’s results are what they are, while analysts are the ones leading us astray.
Can You Trade the Reaction?
Given these uncertainties, trading directly on news updates can seem impossible—or is it?
While you can’t reliably predict the content of a trading update or its initial price impact, you can potentially react to the price movement. Here’s how:
- If a stock gaps up or down by 20% following a trading update, you have the opportunity to enter at a better price than those who held positions before the announcement.
- Taking a contrarian approach, you might benefit from a “gap closure” as the price stabilizes.
- By placing a tight protective stop-loss order, you can manage your risk effectively. Even if the stop is triggered, it’s likely to occur in an orderly fashion rather than being bypassed due to extreme volatility.
This strategy allows you to capitalize on the market’s overreaction while limiting your downside.
In Conclusion
Navigating news-related price gaps is challenging, but by understanding the dynamics of news reactions and adopting a disciplined approach, you can turn unpredictability into opportunity.
