and Tis the elapsed time since the release of the news. In sci-ence this relationship, which represents the physical impact declining with the square ofthe distance (or time), applies directly to sound and light.
Measured empirically, the impact of economic.reports is worth studying. For futuresmarkets, the CFTC releases its Commitments of Traders report each week (upgraded frommonthly reports). It tells the distribution of holdings among large and small speculatorsand hedgers as a percent of total open interest. This report is watched with the idea thatthe small speculators are usually wrong and the large hedgers right (this is covered in alater section of this chapter).
It is important to understand the difference between the analytic and empirical ap-proach to news. In the analytic method, the value Of specific events is determined inadvance, and when they occur their preassigned value is compared with the effects. Usingthe empirical method, the historic effects of each event are tabulated and measured, thenapplied to subsequent news items.
‘The analytic approach has the advantage of working in an environment where multiple
~ events are occurring simultaneously, and only the sum of all news items can be calculated.
‘when testing the empirical approach, the event of interest may not be clearly distinguishedfrom other news of importance occurring at the same time. Finding situations that isolate a
 
MEASURING THE NeWS: 337
 
single type of event, from which you can measure its impact, may be impossible. The pri-mary disadvantage of the analytic approach is that it does not account for the discountingor anticipation of the news. An event of modest importance may become neutral or moresignificant relative to other concurrent or anticipated events; the empirical method wouldnot be subject to that problem since it measures reactions and not expectations.
Trading on the News
Even without a sophisticated method of measurement, there are many professional specu-lators who trade on the news. When a bullish news item or report is introduced and themarket fails to respond upward, the experienced trader looks for a place to sell. It showsthat expectations exceeded reality and prices had already anticipated the bullish interpre-tation of the news; there may be a large number of sellers above the market. Similarly,opening calls, available for most markets, are transmitted via wire services beginning abouta half hour before the opening bell. Regardless of the means for determining the openingdirection, an experienced trader may take advantage of a higher opening call to place a sellorder. There are frequent cases of so many traders wanting to sell a higher opening that theinflux of orders after a call, before the opening, has changed the direction from higher tosharply lower on the open.
Agricultural weather markets function purely on news. Traders with long positions waitfor the 5-day forecast hoping for no rain; they anticipate a loss of a specific number of bushelsper acre for every dry day once the rainfall is below a given level. Weather markets are ner-vous and are characterized by evening-up on weekends; they rely heavily on anticipation andemotion. It is said that a farmer loses his crop three times each year: once for drought, oncefor disease, and once for frost. In 1976, the news carried numerous articles on the desperatewheat crop in the western states, showing films of virtually barren fields, and yet the UnitedStates harvested one of their largest wheat crops on record. Weather markets have a historyof volatile anticipation but are a risky way of making long-term price predictions.
‘The discounting of news is as important as the news itself, An old saying in the market,“Buy the rumor, sell the fact,” implies that anticipation drives the price past the pointwhere it would realistically adjust to news. When the actual figures are released, there isinvariably an adjustment back to their proper level. The pattern of anticipation for eacheconomic report or news event should be watched closely.
Market Selectivity
The market seems to focus on one news item at a time. Although the same factors arealways there to affect prices, they must reach a point of newsworthiness before theybecome the primary driving force. For heating oil, the combination of unexpected, sus-tained cold weather compared with available inventories will activate a weather market.Interest rates, the U.S. dollar, and tension in the Middle East will either be magnified outof proportion or completely ignored, while the anticipation of demand rises sharply. Amarket analysis of shortages not supported by news may as well be discarded—it is moreoften that crowd behavior moves the market.
Media Indicators
In a delightful article,‘ the author Grant Noble argues that the news recognizes eventswhen they are cresting, and most often provides a countertrend trading opportunity. First,the American media should be considered to provide signals in three major time frames:
* Grant Noble, “The best trading indicator—the media,” Technical Analysis of Stocks & Commodities (October 1989). 
 
 
 
338 BEHAVIORAL TECHNIQUES
* Long-term—as given by the large circulation news magazines such as Time andNewsweek. With the timeliness of a brontosaurus, they profile moves over manyyears.
+ Medium-term—represented by Barron’s, Forbes, and Business Week, cover a periodof about 3 months.
+ Short-term—held captive by the Wall Street Journal and the New York Times, whichalso provide intermediate prediction.
By reading these periodicals you find that the Wall Street Journal has run headlines on“killing drought,” “dust bowl,” and the New York Times on “Drought. . . imperils crucialwheat crop” just as the wheat price makes its highs for the current move. In another case,Barron’s cover article asked “Is the bull leaving you behind?” in August 1987. It’s not sur-prising that the media would highlight events only after they have become a popular con-cern, In that sense, we might say that there is a high public consensus, a topic addressed inthe section “Contrary Opinion.” It may be perfectly valid to construct a consensus indica-tor based on the number of square inches of news coverage given to an event in a combi-nation of publications.
EVENT TRADING
‘The largest price moves and the greatest volatility are the result of reactions to unexpectednews. These market events pose the greatest risks to all traders because they are unpre-dictable and of such great magnitude that they are out of proportion with normal tradingrisk. It may be possible to trade for a number of years without experiencing an adverseprice shock; therefore, many traders do not plan properly for these situations. Those read-ers interested in price shocks and their effects should also refer to Chapter 21 (“Testing”).
Not all price shocks are of such magnitude that they present an unmanageable problem.It may be that price moves are cither the reaction to news or the anticipation of news. Thisnews is most often a release of an economic report by a government agency or monetaryauthority, but can also be a natural disaster associated with weather or earthquakes, or a polit-ical event, such as an outbreak of war, a military coup, or an assassination. The U.S. govern-ment releases economic data on an announced schedule, many of them at 7:30 a.m. Chicago.time; that create regular disruptions to price movements in world economic markets.
‘The frequency and size of these price moves, triggered by unexpected hews, makesthese events a natural candidate for a trading system.> The profit opportunity, however,does not lie in taking a position ahead of the anticipated market reaction, but in studyingthe systematic patterns that come after the initial price reaction to the news. Because thenews is unexpected, you cannot predict the results nor the extent of the reaction; therefore,taking a market position in advance of a government report would have a 50% chance ofsuccess and often very high risk. Studies might show that there is a bias in the direction ofthe price shock due to the way the monetary authority plans economic growth and controlsinflation; however, the risks would remain high. This section will only look at positionsentered on the close of the event day, the day_on which a sharp market reaction occurred.
Market Reactions to Reports <
To determine whether there is ample opportunity to profit from the price move that fol-lows an event, it is necessary to study the direction of the market move and the subsequentprice changes that occur over the next few days. These lagged reactions are the results ofmarket inefficiencies; it is unlikely that prices could immediately jump to the exact price
* Ben Warwick, Event Trading (Irwin, 1996).
EVENTTRADING - 339
 
that economic principles require, despite the Efficient Market Hypothesis. With large priceshocks there is often an over- or underreaction that is corrected during the next few days.Sometimes prices jump one direction and immediately begin to go the other way until theyhave completely discounted the price shock.
Figure 14-1 illustrates the types of price movements that might follow an upward priceshock. Where there is an underreaction the prices move higher over the next few days;when there is an overreaction prices move lower. Patterns are not as orderly as shown inFigure 14-1 because volatility is high and many traders react impulsively, or by financialnecessity, to the move. To decide whether a market is a candidate for event trading, youmust study the pattern of moves following the reaction to news and decide whether:
1. The size of the average move is enough to generate a profit.2. The returns are worth the risk of loss associated with these volatile events.
When studying these events, there may be a direct relationship between the size of thereaction and the type of pattern that follows. For example, a small reaction to news may befollowed by a steady continuation. of the direction of the price shock. If unemploymentjumps by 4% in a month, there should be a reaction by the government to stimulate jobgrowth. The same initial reaction would occur if unemployment jumped by 1 full percent,but the number would be so unexpectedly large that it may be considered an error inwhich case it is not clear to what extent the government would respond. The market mayoverreact to a large shock but underreact to a small one. The only way to discover this isby testing these events.
Fundamental to understanding price shocks is that the shock is based on the differ-ence between the expectations and the actual reported data, not just the reported data.The market always discounts what it believes is its best guess at what the report will say;therefore, if bond prices rise in advance of an important unemployment report, we can saythat the market expects unemployment to increase. If bond prices have moved up by 4%(equivalent yield) in expectation of a very bad report, and the report comes out neutral,then prices will drop sharply to offset the incorrect anticipation. When studying marketreactions from historic records of economic data, you must have market expectations to
  
FIGURE 14-1 Price reaction to unexpected news, including delayed response. The upward
price jump on the event day (0) may be followed by (a) a continuation move up or(6) a reverse move down over the next 3 days.
  
340 BEHAVIORAL TECHNIQUES.
 
find consistent results; without those values, the best approach is to work backward fromthe reaction to infer the accuracy of expectations.
Measuring an Event
‘There are many economic statistics released each year, as well as special reports in the WallStreet Journal and other influential periodicals. To record the dates of each news itemwould be impractical for most traders; a simpler approach that might prove effective is toidentify the importance of the event by the size of its reaction. This can be done by com-paring the volatility of the current day with the average volatility of the recent past, usingthe true range calculation:
TUE FANE rods5
volatility ratio =average (Ue FANE nays
When the volatility ratio is below 1.0, current volatility is less than the average volatility
over the past n days. When the ratio is greater than 3.0 we are likely to have identified a day -
in which a news event caused a price shock. The larger the ratio, the greater the surpriseto the market. Note that the true range is used because the shock can occur overnight,causing an opening gap, or during the trading session, when the United States typicallyreleases reports. .
Key Government Reports
Even when there is public concern over the state of the economy, the market does not reactin a similar way to all economic data. Some reports seem to be more important than others,and the market appears to focus on one report at a time. The most significant data seem tobe unemployment and the Consumer Price Index (CPD). During a period of sustained lowunemployment, as seen in 1997, even a modest increase will not cause much concern. Ajump in the CPI, however, will always warn the market to expect a preemptive strike by theFed, cutting off potential inflation by nudging rates up slightly. The Trade Balance report wasparticularly popular in the late 1980s when the deficit with Japan seemed to be at the root ofthe U.S. deficit. Sagging U.S. exports and_overconsumption of foreign-made products byAmericans looked as though the U.S. work force could not compete in the world market.
‘Other reports can also attract the attention of traders, but may be mote difficult tointerpret, Durable goods, retail sales, budget, and tax legislation all directly affect the economy and prices; however, it is not always clear how to relate the changes in durable goodsorders with price change, or how the latest news on tax law will contribute to the eco-nomic well-being. More important, it is difficult to assess how the government will manip-ulate interest rates in reaction to these data.
 
Trading the Event Lag
Once you have studied the way prices move following an event day, or price shock, you can.establish trading rules. For example, you find that a change in the Consumer Price Indexof between 0 and +.2% has no particular reaction, provided market expectations were sim-ilar to the data released. A change between +.2 and +.4 or ~.2 and —.4 should give enoughsurprise for a noticeable market reaction, provided expectations were low, and’ datagreater than a change of *.4 should cause a price shock regardless of the anticipation. Inaddition, we might find that changes over +.4 tended to react in the opposite direction tothe normal government action because of overanticipation. -
Based on the results of studying these patterns, Warwick established the followingtrading rules: -
 
EVENT TRADING 341
 
1. Buy on the close if the market closes in the upper 20% of the trading range on anevent day (a price shock), if prices have shown a continuation pattern,
2. Hold for a predetermined number of days, based on the lag pattern of the market.
3. Use a stop-loss to limit risk.
In an older study by Arnold Larson® applied to the corn market, it was found that 81%of the price changes occurred on the event day, there was a typical price reversal of 8% overthe next 4 days, and a net change in price of 27% in the original direction over 45 days.Although we should not expect those same numbers now, the pattern of a large move, areaction, and a longer directional move may still be valid
Results of Event Studies
In his book Event Trading, Warwick shows the test results of some of the major markets,allowing us to compare the effects of the systematic reaction of U.S. bonds with that of theS&P 500 and other markets. Unexpected news that causes bond prices to rally sharply(causing rates to decline) would result in a rise in the stock market, unless the news wasparticularly bad for the long-term economy of the country. Therefore, a drop in the con-sumption of durable goods should be followed by lower interest rates and a slightly laggedupward response in the stock market. This pattern is shown in Table 14-1 where the bondand S&P results are side-by-side:
In general, we expect a price shock to impact interest rates first, then currency andequities markets. Typically, the interest rates react in a way to compensate for the economiceffects and stabilize the other two markets; this preempts the action that would beexpected from the Central Bank. The exception is when the news is much more extremethan usual, and it affects the stock market first. Investors, because of a lack of confidence,will shift their funds from equities to interest rates in an effort to find a safe haven duringuncertainty. This will cause a decline in the stock market and a corresponding rise in inter-est rate prices (lower yields), although normally the two will move in the same direction.
In Table 14-1 we can see the way the markets move after both the interest rates andstock market initially react with an upward price breakout. When both markets continue inthe same direction, such as with retail sales, GDR and employment data, then the fullimpact of the data takes longer to be assessed by the market, or there is expectation of
6 Arnold Larson, “Measurement of a Random Process in Futures Pricing,” Food Research Institute Studies I (no.3, November 1960, referenced in Warwick, Event Trading).
TABLE 14-1 Results of Upward Breakout of U.S. Bonds (left) and S&P 500 (right) for thePeriod 1989-1994
 
 
- U.S. Bonds S&P 500Holding Buy or ~— Confidence Holding Buy or ConfidencePeriod Sell Level Period Sell tevelDurable goods o1 B 97 4 B >99Retail sales oi B 90 0-2 B 96Retail sales 1s s 95 24 s 9cP Low confidence 03 B 92PPI oS s 95 1 B 7NAPM 0-2 B a o4 s 7Industrial production ol s 94 Low confidenceGoP - 03 8 90 o4 B 96Employment 0-2 8 a o-1 B 93
en 
 
 
342 BEHAVIORAL TECHNIQUES,
some continued response by the government. The PPI and the National Association of Pur-chasing Managers (NAPM) do not show this consistency, indicating that the market takesthis information differently. When the pattern of confidence is low, the market may do agood job of reaching the best price level in immediate response to the news; therefore,there is no consistency in the price move that follows.
Table 14-2 shows the side-by-side test results of reactions that cause a drop in bondprices and a corresponding drop in the S&P $00. The frequency of low-confidence resultsmay represent the conflict between the normal upward bias of the stock market or theunusually bullish trend during the test period. The GDP results, which show the most con-fidence, indicate that the stock market moves higher even when the interest rates rise inreaction to positive GDP data. Trade balance data, which is not always the primary focus ofthe market, has a very consistent pattern, but is not clearly related to the interest rate moveas are most of the other statistics.
Although this work concentrates on the short-term daily reaction to unexpected news,the long-term trend should not be overlooked. Economic data can exhibit consistency overlong time periods, and the response by the Central Bank is usually moderate but consis-tent. If the CPI shows early signs of inflation, then the monetary authority will push ratesup slightly; if this doesn’t work, as seen by the next series of economic reports, they willmove rates slightly higher again. This pattern allows for an underlying tend that can beused to filter the direction of trades and add confidence to the results.
Reaction to Unemployment Reports
Markets treat unempfoyment data seriously; because it is a direct reflection of how thepopulation is faring, the government is sensitive to unexpected changes in the number ofpersons filing for unemployment benefits. Using LIM, it was found that when the marketunderestimated the unemployment figure by at least 0.2%, there was an average return of4.5% in the S&P 500 during the following 27 days from the close of the report day. Simi-larly, U.S. 30-year Treasury bonds showed an average return (from a long position) innearly all cases of 3.2% during the period from 3 to 28 days following the report.”
7 Gibbons Burke, “Event-based Analysis," Futures (April 1995).
TABLE 14-2 Results of Downward Breakout of U.S. Bonds (left) and S&P 500 (right)for the Period 1989-1994
 
 
 
ULS. Bonds S&P 500Holding Buy or Confidence Holding Buy or ConfidencePeriod Self Level Period Sell LevelDurable goods Low confidence 0-2 B 2Retail sales Low confidence 04 B 94Renail sales Low confidence Low confidencecP o4 s 97 ar Low confidencePPI Low confidence Low confidenceNAPM Low confidence Low confidenceIndustrial production 0-4 s 93 Low confidenceGDP 0-3 s 9 0-3 B 399Industrial production 3-4 8 >99 03 B 299Employment. Od s 93 Low confidenceTrade balance 0-3 s 93 0-3 s 99
 
EVENT TRADING 343
Presidential Election Cycle
Of all the events that move the market, the Presidential elections have been the most con-sistent. The patterns stem from the motivation of the incumbent party to provide goodeconomic news to the voters prior to the election year, and as far into the election year aspossible. Stock market action during the election year is always more erratic, as parties bat-tle over the value of each other's actions.
Studies of the 4-year patterns have all yielded very similar results to those shown inTable 14-3.* The year preceding the election (year 3) posts the strongest gains for the mar-ket, followed by a reasonably strong election year. The 2 years after the election showreturns below average as the reality of politics reasserts itself.
‘There is the additional possibility that there is an 8-year cycle that should be watched;however, the 8-year period should be most informative if it represented only those years inwhich the same President was in office. Actions by a President who cannot be reelected arelikely to be different from one who seeks another term, therefore, we should expect a dif-ferent pattern. This can be made more intricate by studying the patterns preceding and fol-lowing a change of party, all of which have a fundamental basis in the behavior of thepolitical parties and the voters.
More sophisticated computer software, such as provided by Logical InformationMachines, a Chicago firm, can produce a very interesting, closer view of how voters respondto election politics. Table 14-4 breaks the election year into periods between the key eventsfor those years in which the stock market began the election year within 8% of its 2-year highprice (days refer to business days):
1. The returns of the year preceding the election year
2. The first 10 days of the new year, typically a strong period (days 0-10)3. Through the State-of-the-Union address and the primaries (days 10-83)4, Waiting for the conventions (days 83-161)
5. Preelection blahs—the actual campaign (days 161-195)
6. The election to year-end reaction (days 195-253)
7. Combined periods (2) + (4) + (6)
Combining the three periods (2), (4), and (6), which have strong upward biases, gives con-sistently positive results. Even if the newly elected party fails to deliver on their campaignpromises, traders could have already converted those marketing gimmicks into stock mar-ket profits.
"articles by Adam White, “The Eight-Year Presidential Election Pattern,” Technical Analysis of Stocks & Com-modities (November 1994); Arthur A. Merrill, “The Presidential Election Cycle,” Zechnical Analysis of Stocks &Commodities (March 1992); and Michael J. Carr, “Get out the vote and into stocks,” Futures (February 1996), allshow very similar results for the 4-year election pattern. -
TABLE 14-3. The Presidential Election Cycle, —1912-1992, Based on the Percentage Returns =of the Dow Jones Industrial Averages
 
Preelection year 11.0%Election year 7.0Postelection year 47Midterm year 23Average year “6.3%
Source: Adam White. 
 
344 BEHAVIORAL TECHNIQUES
 
—_—
   
 
 
STABLE 14-4 Election YeaP Analysis for Years in Which the Stock Market Began the Yearwithin 8% of the Previous Two-Year Highs \1 2. First 3. 4 5. 6. Election
Previous 2 weeks Primaries Preconvention —Preelection_—_to year-end 7.Year Year (I-10) (10-83) == (83-161) (161-195) __ (195-253) __(I) + (3) + (5)1936 41.82 2.76 4.64 191 0.62 5.85 20.521944 19.45 1.63 —84 9.27 —86 3.14 14.041952 16.15 1.60 -2.82 8.02 -2.49 SAT 15.101956 725-178 5.42 3.16 6.65 2.38 3.761960 848 0 _-2.49 5.75 2.94 “7.13 8.49 8.951964 18.89 1.79 444 3.03 252 0.06 4881968 20.03 0.26 0.10 144 439 425 5.951972 10.82 ial 3.39 5.30 -1.78 488 11591980 1231 2.26 S42 18.57 0.20 7.66 28.491984 17.53 127 -5.01 427 o4l 0.63 6.171992 26.30 0.80 -2.72 214 0.23 5.87 8.82Average 19.91 0.86 0.44 6.37 1.18 443 11.66
eeSource: Michael Carr, Logical Information Machines.
COMMITMENT OF TRADERS REPORT
Drawing from more than 20 years of experience in analyzing the CFTC’s Commitment ofTraders Report, William L. Jiler described a supplementary approach to identifying a majortrend in his 1985 CRB Commodity Yearbook. With his usual thoroughness and clarity, Jilerpresents material that had previously been unsuccessfully interpreted.
Originally released the 11th day of each month (biweekly since 1992), the Commitmentof Traders Report summarizes the positions of reporting and nonreporting traders as of thelast day of the previous month. Reported positions are those exceeding a minimum leveldetermined for each futures market (e.g., 750,000 bushels for corn, 500,000 for soybeans,500 contracts for 30-year Treasury bonds, and 300 contracts for the S&P 500). The reportsubdivides the open interest into positions held by hedgers (commercials) and speculators.By subtracting the reported positions from the total open interest, the total positions of smallhedgers and speculators can be found. For grain reports (Figure 14-2), positions are furtherdivided into old crop and other positions, which include new crop and intercrop spreading
Jo analyze the shifis in position, Jiler has compiled tables of normal patterns, similar toa seasonal study (Figure 14-3). When the open interest of one group is significantly greaterthan their normal holdings, they express a definite opinion off the direction of the market. Bytracking these changes for many years and observing the corresponding price changes, Jilerconcludes that the large traders have the best forecasting record, with the large hedger betterthan the large speculator. The small traders were notably worse. Guidelines were stated as:
‘The most bullish configuration would show large hedgers heavily net long morethan normal, large speculators clearly net long, small traders heavily net shortmore than seasonal. The shades of bullishness are varied all the way to the mostbearish configuration, which would have these groups in opposite positions—large hedgers heavily net short, and so forth. There are two caution flags when an-alyzing deviations from normal. Be wary of positions that are more than 40% fromtheir long-term average and disregard deviations of less than 5%.
9 William L. Jiler, “Analysis of the CFTC Commitments of Traders Reports Can Help You Forecast Futures Prices,”1985 CRB Commodity Year Book (Commodity Research Bureau, Jersey City, NJ, 1985).
COMMITMENT OF-+ XADERS REPORT 345
FIGURE 14-2 Commitment of Traders Report.
‘DOVREANG — CHICAGO BOARD OF TRADE__SOPMITHENTS OF TRADERS IN ALL FUTURES. COnmIMED At@ THOICATED FUTURES. FEBRUARY ZO. i905
(inCUsAND BUSHELS?
13,919 32-400 41,060 41,040 117.420 140,380 174.290 213.040. 184. 00 14.see s 13 128. 700 380 195, 399, a 3
re 683 %070 “gees “Sees 41-998 tivago 26,910 2.463 {8
Ron sawany 21. 1995"P00" "14.360 “44.770 29.400 -10. 915:
MAMBER OF TRADERS IN EACH CATEGORY
3233 soa32S ES3
   
CONCENTRATION RATIOS”
 
FIGURE 14-3 _Jiler’s normal trader positions.
 
‘SOYBEANS
CHICAGO (6yr. avg. — 1978, 79,80, 81,83,84) %| _+25]
  
+20]
Small Traders ==
Large Speculators
Large Hedgers
13 27:10 24 9 23/6 20'4 18 1 15.2913 2710 24] 14 28 12 26.9 23] 14 rieef aan. | ree, [mae] apr. | may [une | suvr | auc fserr| ocr. | nov | vec. - 
nied
346 BEHAVIORAL TECHNIQUES,
This result is confirmed by Curtis Arnold,"® who compared positions of large and smallspeculators with commefcials for a 1-year period spanning 1983-1984. Arnold shows (Fig-ure 14-4) that the position of commercials and small speculators tend to be'opposite, withthe commercials positioned to profit from the subsequent price move.
Over a wider group of 36 markets from 1983 to 1989, a study conducted by BullishReview" showed that a large weighting of long or short positions held by