<s> Trading Catalysts
Trading CatalystsHow Events Move Marketsand Create TradingOpportunities
Robert I. Webb
Vice President, Editor-in-Chief: Tim MooreExecutive Editor: Jim BoydSeries Editor: Robert I. WebbEditorial Assistant: Pam BolandDevelopment Editor: Russ HallAssociate Editor-in-Chief and Director of Marketing: Amy NeidlingerCover Designer: Solid State GraphicsManaging Editor: Gina KanouseProject Editor: Jennifer CramerCopy Editor: Kelli BrooksIndexer: Lisa StumpfCompositor: Nonie RatcliffManufacturing Buyer: Dan Uhrig© 2007 by Pearson Education, Inc.Publishing as FT PressUpper Saddle River, New Jersey 07458Financial Times Press offers excellent discounts on this book when ordered inquantity for bulk purchases or special sales. For more information, pleasecontact U.S. Corporate and Government Sales, 1-800-382-3419, corpsales@pearsontechgroup.com. For sales outside the U.S., please contact InternationalSales at international@pearsoned.com.Company and product names mentioned herein are the trademarks or registeredtrademarks of their respective owners.All rights reserved. No part of this book may be reproduced, in any form or by anymeans, without permission in writing from the publisher.Printed in the United States of AmericaFirst Printing October 2006ISBN 0-13-038556-5Pearson Education LTD.Pearson Education Australia PTY, Limited.Pearson Education Singapore, Pte. Ltd.Pearson Education North Asia, Ltd.Pearson Education Canada, Ltd.Pearson Educatión de Mexico, S.A. de C.V.Pearson Education—JapanPearson Education Malaysia, Pte. Ltd.Library of Congress Cataloging-in-Publication DataWebb, Robert Ivory, 1952Trading catalysts : how events move markets and create trading opportunities /Robert I. Webb.p. cm.Includes bibliographical references.ISBN 0-13-038556-5 (hardback : alk. paper) 1. Stock price forecasting. 2. Business cycles. 3. Speculation. I. Title.HG4637.W43 2006332.64’5—dc222006019367
To my wife, Mary Beth, and my children,Alexander, Elizabeth, and Diana.
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CONTENTSPreface
xv
Chapter 1:
Introduction 1Federal Reserve Rate CutAnnouncement 1Analyzing the Market Reaction 8The Nature of Trading Catalysts 10Do Perceived Trading Catalysts ReallyInfluence Market Prices? 18Trading Catalysts and MarketEfficiency 21Trading Is a Game 23Trading Off of Catalysts 24References 28Endnotes 29
Chapter 2:
Market Conditions and Sentiment 33Treasury Announcement DiscontinuingIssuance of 30-Year Bonds 33Market Conditions, Sentiment,and Trading Catalysts 40Treasury Announcement of PotentialResumption of 30-Year BondIssuance 46Trading Lessons 54References 57Endnotes 58
Chapter 3:
Talk Isn’t Cheap 61Irrational Exuberance 61Comments by Politicians andPolicymakers as Trading Catalysts
66
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CONTENTS
Greenspan Speaks andMarkets Move 69Other Voices at the Fed 70The Asian Financial Crisis 71Broken Promises 72Speculation or Fundamentals? 74A Trading Pattern Emerges 75Other Voices Impact the FX MarketSpeech Is Silver 77
76
Mr. Yen 79Lost in Translation 82Trading Lessons 83References 86Endnotes 88Chapter 4:
Geopolitical Events 91War with Iraq 91Geopolitical Events asTrading Catalysts 100The Arrest ofMikhail Khodorkovsky 102Elections 103May 2004 Indian ParliamentaryElection 104The Brazilian Presidential Electionof 2002 1061992 Maastricht Treaty Referendum2005 European Union ConstitutionReferenda 108
Terrorist Actions
107
112
September 11, 2001 114Madrid Train Bombings,March 11, 2004 117Terror in London, July 7, 2005
119
Impeachment of South Korean PresidentRoh Moo-hyun 120
CONTENTS
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Coup d’Etat: The GorbachevOuster 122Trading Lessons 124References 125Endnotes 128Chapter 5:
Weather and Natural Disasters 133A Tale of Two Natural Disasters 133Natural Disasters asTrading Catalysts 140Contamination of the Food Supply:Mad Cow Disease 141Potential Epidemics and Pandemics:SARS 147
Weather Conditions 149Other Natural Disasters 155Hurricane Andrew and PrepaymentSpeed 155The Chicago Flood 155The San Francisco Earthquake 156
Trading Lessons 156References 158Endnotes 159Chapter 6:
Market Interventions 163A Tale of Two Market InterventionsCentral Banks Defend the Euro 164Tapping the Strategic PetroleumReserve 168
Market Interventions as TradingCatalysts 171Defending the Indefensible 175The Hong Kong Monetary AuthorityIntervenes in the Stock Market 180Trading Lessons 185References 187Endnotes 189
163
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CONTENTS
Chapter 7:
Periodic Economic Reports 193The Trade Deficit Sparks a BondMarket Rout 193The Trade Deficit Sparks a BondMarket Rally 198Scheduled Economic Reports 202What Is Fundamental EconomicInformation? 207Noise and Information 211Trade Selection and Trade Horizon 212Trading Lessons 217References 220Endnotes 222
Chapter 8:
Size Matters 227Blood in the Water 1: Sumitomo Is Longand Wrong 227Blood in the Water 2: The Yen SuddenlyRises 233Internal Market Catalysts 239Order Size as a Trading Catalyst 242Electronic Trading Games: Citigroup HitsAll Bids—August 2004 243Size Matters: March 1996 CBOT WheatFutures 246Trade Execution Matters 247
Precursor to the 1987 CrashTrading Lessons 251References 253Endnotes 255Chapter 9:
249
Bubbles, Crashes, Corners,and Market Crises 259The Silver Corner 260Internal Market Catalysts 271The Crash of 1987 280
CONTENTS
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Asian Financial Crisis and MarketContagion 294Trading Lessons 295References 297Endnotes 300Chapter 10:
The Accidental Catalyst 305The Large Cost of Small Errors 305Lost in Translation 310Dollars or Shares? 312Trading Lessons and Summary 315Market Conditions, Sentiment,and Trading Theses 317Trading Is a Game 319News: Information versus Noise 319The Origin of Trading Catalysts 321Extreme Events 322
References 324Endnotes 325Index
327
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ABOUT THE AUTHORRobert I. Webb is the Marvin J. Patsel, Jr., Research Professorand Director of the Center for Financial Innovation at the McIntireSchool of Commerce of the University of Virginia. He is also a visitingprofessor at the Darden Graduate School of Business Administrationat the University of Virginia where he teaches Financial Trading. Bobserves as editor for the Journal of Futures Markets—a leading academic journal that specializes in publishing articles on derivativesecurities and markets. His experience includes: trading fixed incomesecurities for the Investment Department of the World Bank; tradingfinancial futures and options on the floor of the Chicago MercantileExchange; designing new financial futures and option contracts forthe Chicago Mercantile Exchange; analyzing the effects of deregulating the financial services industry, among others, at the ExecutiveOffice of the President, Office of Management and Budget; andexamining issues related to international futures markets at the U.S.Commodity Futures Trading Commission. Bob has also consulted onrisk management issues for the Asian Development Bank. He formerly taught at the Graduate School of Business at the University ofSouthern California. Bob received his M.B.A. and Ph.D. in financefrom the University of Chicago and his B.B.A. from the University ofWisconsin Eau Claire. He has written articles for a number of academic journals and the financial press. Bob is the author of Macroeconomic Information and Financial Trading (Blackwell, 1994).
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PREFACEThis book owes its origin to my long fascination with the behavior ofspeculative prices, in general, and extreme market moves, in particular. My interest is driven by both intellectual curiosity about hownews is incorporated into market prices and fascination with thepotential for large gains or losses associated with trading aroundextreme market moves. This book is the culmination of many years ofobserving changes in financial market prices up close, as a trader, andat a distance, as a professor.I was a doctoral student at the University of Chicago GraduateSchool of Business when the finance faculty included Fischer Black,Eugene Fama, Merton Miller, and Myron Scholes, among others;and the statistics faculty included Arnold Zellner—the brilliantBayesian econometrician. Chicago was the birthplace of the efficientmarkets hypothesis—the notion that security prices fully and correctly reflect available information. However, the process by whichnew information was impounded into market prices was largely ablack box. Although I was a student at Chicago during arguably thepeak of the influence of the efficient markets hypothesis on academicresearch, the fundamental takeaway from my studies at Chicago wasnot the presumptive validity of market efficiency, or any other theoryfor that matter, but rather the importance of empiricism—that is,what do the data tell us? Indeed, the theory of market efficiency originated from seemingly puzzling observations by Maurice Kendall,Holbrook Working, and Harry Roberts that changes in speculativeprices appeared to follow a random walk.I was a newly minted Ph.D., and an assistant professor at theUniversity of Southern California, when I watched silver and goldprices sometimes rise or fall sharply on a number of days during
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PREFACE
the autumn of 1979. Clearly, the movements were too large andvolatile to be explained by the arrival of new information alone, as theefficient markets hypothesis would suggest. Equally clearly, theactions of certain traders played a key role in many of the pricemoves. This episode eroded my belief in the validity of the efficientmarkets hypothesis, but increased my curiosity over how news isimpounded into speculative prices.1 It also led me to secure a twoyear leave of absence from the University of Southern California andaccept an appointment at the Commodity Futures Trading Commission in Washington, D.C. in 1980.At the time, the Commodity Futures Trading Commission was arelatively new Federal Agency, having been created in 1974. Not surprisingly, the then-recent attempted “silver corner” was a commontopic of conversation among Commission staffers as were other issuesrelated to market surveillance. My work at the Commission gave mean opportunity to see raw news as it was reported. The Commissionhad a teletype machine that received news bulletins. The machinewas located in a hallway closet next to the water fountain. I wouldstop by several times a day to read the latest news off the wires. Iquickly recognized the important role that news editors play as Isorted through mounds of fluff for the occasional nugget of news.However, even bona fide news did not always seem to have the predicted impact on market prices.My career took a slight detour when I was offered an opportunityto serve in the Executive Office of the President, Office of Management and Budget (OMB) in 1981. My boss at OMB was Larry Kudlow. The emphasis on domestic economic policy during PresidentReagan’s first term meant that OMB was the place to be in the Reagan Administration at the time—until OMB Director David Stockman was “taken to the woodshed” by the White House for someill-advised comments.
PREFACE
xvii
When my two-year leave of absence was up at USC in 1982, Ichose to enter the private sector and accepted a position as SeniorFinancial Economist at the Chicago Mercantile Exchange (CME),where I helped design new financial futures and option contracts. Itwas an exciting time to be at the CME as stock index futures contractshad only been introduced in April 1982, just months before I arrived.Working at the CME also afforded me the opportunity to observe theopen outcry system on a daily basis from the vantage point of theexchange floor. The only thing that I was precluded from doing wasentering the trading pits themselves—that was reserved for CMEmembers (i.e., seat holders) and CME pit reporters. Active days wereespecially exciting to watch and I availed myself of every opportunityto do so. Although I was closer to the market, I was not closer tounderstanding how news is impounded into market prices. I left myposition as an employee of the CME in 1983 and became a memberof the Index and Options Market division of the CME. I was insidethe “black box” at last. Finally, I hoped to get an answer to my question of how news is impounded into market prices.An open outcry futures trading pit provides an unusually goodvantage point from which to view the determination of market pricesbecause a large fraction of total trades in an open outcry environmentare between locals. Life as a “local” was fast-paced and exciting onactive days, boring on tranquil days, but always intellectually challenging. I quickly found that many of the preconceptions I had abouthow speculative prices should behave were wrong. My advancedtraining in finance was initially a disadvantage in the pit because itmade me intellectually rigid rather than flexible and open to newideas. Some intellectual baggage was discarded. At the same time, mytraining at Chicago also helped me discover many potentially profitable trades. I saw firsthand the wide range of factors that couldimpact market prices in the short run.In 1986, I returned to academia when I accepted a position at theUniversity of Virginia. Almost immediately upon my arrival, I was
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PREFACE
approached by the World Bank. At the conclusion of my first academic year at Virginia, I took a 15-month leave of absence to work inthe Investment Department at the World Bank in May of 1987. Atthe time, the Investment Department was an active trader in fixedincome markets—trading almost as much as a primary governmentsecurities dealer. The Investment Department managed a liquidityportfolio of about $19 billion to $22 billion, depending upon whetherInternational Development Association and International FinanceCorporation funds were included. (The purpose of the liquidity portfolio is to allow the Bank to continue to perform its principal functionof lending to developing countries in the event of a financial crisis.)These monies were invested in high-grade sovereign securities. Befitting its status and its immense trading volume, the World Bank haddirect telephone lines to the major investment and commercialbanks. I rotated around the trading desk. My experience trading onthe floor of the CME proved to be immensely valuable when I tradedfixed income securities for the World Bank.However, the experience of trading in the Investment Department of the World Bank also presented me with a new set of anomalies to think about. One group of these anomalies—the oftenpuzzling reactions of fixed income prices to scheduled economicreports—inspired my book Macroeconomic Information and Financial Trading (Blackwell, 1994). I was fortunate to be on the tradingfloor during the stock market crash of Monday, October 19, 1987where I observed the limited (and initially negative) reaction of theU.S. Treasury bond market to the crash. A few hours after the U.S.stock market closed, however, Treasury bonds scored their largestone-day rally ever in a delayed reaction to the stock market crash.After my leave of absence was up, I returned to the University ofVirginia. In addition to writing articles for academic journals, I wrotea number of opinion pieces for various publications including TheWall Street Journal, the Nihon Keizai Shimbun, the Nikkei Weekly,and Investors Business Daily. In 1994, at the request of students, I
PREFACE
xix
started teaching a course on Financial Trading at both the McIntireSchool of Commerce and the Darden Graduate School of BusinessAdministration at the University of Virginia. One of my former students, Andrew Peskin, was a particular help to me in that regard. Anumber of prominent traders, fund managers, and fund of fund managers have lectured to students in the course over the years includingArki Busson, John Henry, Paul Tudor Jones II, Peter Matthews,Drew Millstein, R. Jerry Parker, and Jeff Yass, among others. Thecomments of many of these speakers on the issues of the day havealso influenced my views on the behavior of speculative prices. In1998, I was appointed editor of the Journal of Futures Markets—aleading academic journal on derivative securities and markets. TheJournal of Futures Markets has had two special issues on trading during my editorship.This book has benefited from many conversations that I have hadover the years with Hesham El-Naggar, Rick Gerson, Richard Jaycobs, Gary Schirr, Paul Staneski, and Jules Staniewicz on a whole hostof financial topics. I would also like to thank Victor Canto andRichard Leonard for their steadfast encouragement to write thisbook. A special note of thanks is due to Jim Boyd, Executive Editor atFT Press, and to Melody Koh for her research assistance in producing the various figures included in this book.Finally, I would like to thank my wife, Mary Beth, my threechildren, Alexander, Elizabeth, and Diana, as well as members of myimmediate family, for the patience, love, and encouragement thatthey showed me while I was writing this book.Robert I. Webb
Endnote1
That said, the concept of informational market efficiency is a useful benchmarkby which to measure the value of private information and assess whether thereare any hidden risks associated with potential trades. Grossly inefficient marketprices are unlikely to persist for an extended period of time.
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1INTRODUCTION
“In War more than anywhere else in the world things happendifferently to what we had expected, and look differentlywhen near, to what they did at a distance.”—Carl von Clausewitz1
Federal Reserve Rate Cut AnnouncementAt approximately 1:14 in the afternoon of January 3, 2001, the Federal Reserve announced a 50 basis point cut in the targeted Fed fundsrate.2 The announcement was intended to surprise market participants, and it did—coming almost four weeks before the next regularlyscheduled meeting of the Federal Reserve Open Market Committeeon January 30, 2001. The impact on the stock market was immediate.Stock prices rose sharply in reaction to the news. Many large Nasdaqlisted stocks soared. JDS Uniphase closed up 36.6%. Sun Computers1
2
TRADING CATALYSTS
closed up 29.9%. Amazon closed up 26.5%. Adobe Systems closed up23.9%. Oracle closed up 21.3%. Even Microsoft managed to eke outa double-digit gain and closed up 10.5% for the day. Not surprisingly,the Nasdaq Composite Index reflected the broad gains enjoyed bymany of its component stocks.The performance of the cubes or QQQs—the tracking stock forthe Nasdaq 100 stock index—also mirrored the rally in the underlyingstocks of the index.3Perhaps, the strength of the rally is best illustrated by the reactionof Nasdaq 100 stock index futures contract prices to the announcement.4 At one point, the price of Nasdaq stock index futurescontracts—which usually leads the underlying Nasdaq 100 stockindex—was up more than 20% in response to the announcement.Nasdaq 100 stock index futures contracts are traded on theChicago Mercantile Exchange. For many commodities, the mostactively traded futures contract is the nearby or front month contract(i.e., the contract closest to expiration).5 This was certainly true forthe Nasdaq 100 stock index futures contract on January 3, 2001, whenthe March 2001 futures contract was the most actively traded Nasdaq100 stock index futures contract.6Prior to the Fed announcement, Nasdaq 100 stock index futureswere trading in 1 to 2 full point increments—that is, the change innotional value of the contract when futures prices changed rangedfrom $100 to $200. The Nasdaq 100 stock index futures contracttraded at 2173 immediately before the announcement. Immediatelyafter the announcement, the Nasdaq stock index futures pricejumped by 5 full points to 2178. This was only the beginning of themove. For the next 48 seconds, the contract largely moved up (butsometimes down) in 5-point increments rising to 2240. The reactionthen accelerated. For the next 75 seconds, the contract largely movedin 10-point increments rising to 2340. The reaction continued. Overthe next 34 seconds, the contract had a 30-point move followed by20- and 10-point moves.
CHAPTER 1 • INTRODUCTION
3
All of this occurred within three minutes of the announcement.Then, incredibly, the reaction intensified even further, and the market started moving in 50-point increments up or down. The marketcontinued to bounce between 2400 and 2650 largely in 50-pointincrements over the next minute and one half. That is, the marketwent from bouncing $100 to $200 between price changes before theFed announcement to bouncing $5,000 between price changes a fewminutes after the Fed announcement. The bid ask spread was notrecorded. However, if one regards the bounce as a proxy for the bidoffer spread, then it widened by as much as 25 to 50 times its preannouncement amount after the Fed announcement. At this point,the Nasdaq stock index futures market was up a stunning 22% intraday (i.e., during the trading day).To put the size of this price move in perspective, on Black Monday, October 28, 1929—the first day of the two-day 1929 stock marketcrash—the Dow Jones Industrial Average (DJIA) was down 13.5%.On Black Tuesday, October 29, 1929, the DJIA was down another11.5%.7 The percentage decline in the DJIA on Monday, October 19,1987—another stock market crash—was more than 23%. Stock market crashes are considered extreme events, yet the Nasdaq index wasup in a few minutes almost the same percentage amount as theseindexes fell in one or two days. Another way of looking at it is that theaverage annual return earned on a diversified portfolio of stocks oflarge U.S. companies over the 1926 to 1999 period was 13.3% and17.6% for a portfolio of small company stocks according to Jack C.Francis and Roger Ibbotson.8 Yet, the intraday move in the Nasdaq100 spot and futures exceeded both of these annual stock returns.Clearly, this was a large reaction in stock prices by any measure.The initial reaction, however, apparently entailed a substantialoverreaction as the futures price subsequently fell from the high of2650. The size of the price changes narrowed to mostly $25 movesover the next two minutes as the market fell to 2425. This was followed by a period of largely 5-point moves and some 10-point moves
4
TRADING CATALYSTS
over the next 21 minutes as the market rose back up to 2480. TheNasdaq 100 stock index futures contract closed up for the day approximately 16.7%, whereas the underlying Nasdaq 100 index closed up18.77%.9 The more widely reported and related Nasdaq CompositeIndex closed up 324 points, or about 14%. In contrast, the S&P 50stock index closed up 64 points, or 5%, whereas the Dow JonesIndustrial Average closed up 299 points, or 2.8%, for the day.10 Figures 1.1, 1.2, and 1.3 depict the daily trading range (high to low) ofvalues for the Nasdaq Composite Index, Nasdaq 100 stock indexfutures contract, and the Dow Jones Industrial Average for a numberof days before and after the surprise cut in the targeted Fed Fundsrate.11
3500.00
1/3/2001date.open 2254.56date.high 2618.03date.low 2251.71date.close 2616.69
3400.003300.003200.003100.00
1/3/2001Fed Funds rate cut
3000.002900.002800.00
CHAPTER 1 • INTRODUCTION
3600.00
2700.002600.002500.002400.002300.002200.002100.002000.0011/1/00
12/1/00
1/1/01
2/1/01
Nasdaq Composite Index reacts to Fed Funds rate cut on January 3, 2001. Daily trading range of the Nasdaq Composite Index fromNovember 1, 2000 to February 28, 2001.
FIGURE 1.1 The Fed sparks a rally on Nasdaq.
5
6
3500.003400.003300.003200.003100.003000.002900.002800.002700.002600.002500.002400.002300.002200.002100.002000.001900.001800.0011/1/00
1/3/2001Fed Funds rate cut
12/1/00
1/1/01
1/3/2001date.open 2179.50date.high 2650.00date.low 2108.00date.close 2529.50
2/1/01
FIGURE 1.2
Nasdaq futures soar higher than the Nasdaq Composite.
TRADING CATALYSTS
CME Nasdaq 100 stock index futures prices react to Fed Funds rate cut of January 3, 2001. Daily trading range of the frontmonth CME Nasdaq 100 stock index futures contract from November 1, 2000 to February 28, 2001.
CHAPTER 1 • INTRODUCTION
11100.001/3/2001Fed Funds rate cut
11000.0010900.0010800.0010700.0010600.0010500.00
1/3/2001date.open 10637.97date.high 11019.05date.low 10581.09date.close 10945.75
10400.0010300.0010200.0011/1/00
12/1/00
1/1/01
2/1/01
The Dow Jones Industrial Average reacts to the Fed Funds rate cut of January 3, 2001. Daily trading range of the Dow Jones Industrial Averagefrom November 1, 2000 to February 28, 2001.
FIGURE 1.3
Blue chips rally but not as much as the Nasdaq in percentage terms.
7
8
TRADING CATALYSTS
Analyzing the Market ReactionThe financial market reaction to the Federal Reserve announcementis both fascinating and puzzling. It illustrates the powerful impactthat 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 theFederal Reserve and by the fact that the announcement came as asurprise to most market participants. The reaction may also havebeen exacerbated by the fact that the Nasdaq Composite plunged7.23% the day before. However, the size of the reaction in the Nasdaq spot and futures markets was enormous. And, other potentialtrading 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 acase of euphoria or a logical response to the arrival of new information? Why did the Dow Jones Industrial Average and the Nasdaq spotand futures markets react so differently in magnitude to the samepiece of news? Why did the Nasdaq futures market apparently overreact to the Fed announcement? Was the reaction of market prices tothe catalyst alone or did the market feed on itself? What role did theelectronically traded Nasdaq e-mini futures contract play inimpounding the news of the rate cut?The behavior of financial market prices in response to tradingcatalysts is of keen interest to traders, investors, and policymakersalike. Traders are less interested in whether the response of marketprices to a particular trading catalyst accords with what financial economic theory would predict than with how the response impacts theirtrading opportunities and affects their trading strategies.Traders have a different, but related, set of questions to answerwhen an unexpected trading catalyst occurs.1. Which market or markets are most likely to be affected? Theanswer to this question depends on the prevailing trading
CHAPTER 1 • INTRODUCTION
9
thesis (i.e., the perceived relationships between the catalystand financial market prices). The belief that an unexpectedincrease in employment would cause the overall bond marketto tumble is an example of a trading thesis.2. What is the likely direction of the price move? (The answer tothis question depends, in turn, on what market consensusexpectations, if any, were before the catalyst occurred.) Forinstance, many participants believe that a larger than expectedincrease in employment would cause bond prices to fall,whereas a smaller than expected increase in employmentwould 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