grew as time passed during the firstfew minutes rather than declined in amplitude as time passed. Thisphenomenon is sometimes observed for trading catalysts that inducea delayed market reaction where the effect grows as time passesrather than diminishes. Another example in this regard is the reactionin the Indian stock market to news of the Congress’ party’s apparentvictory in 2004. Yet another example is the reaction of Japanese markets to news of the Kobe earthquake in 1995. Both of these examplesare discussed in more detail in Chapter 4, “Geopolitical Events,” andChapter 5, “Weather and Natural Disasters” respectively.This book primarily focuses on trading catalysts that induce orseemingly induce large changes in prices. However, it also considerstrading catalysts that may seemingly start a new trend in prices or reinforce an existing one. Basically, it is recognized that the impact of atrading catalyst may not be limited to a single trading day. Sometimes,there is a small reaction that accumulates into a large reaction overtime. For instance, buying or selling frenzies or panics may extend andaccelerate over time before climaxing. Most trend-following traderswait for the price action in the market to dictate when to enter or exita position. The example that opens this chapter also illustrates a situation in which a positive short-term trend followed the Federal Reserveaction.Trading catalysts occur with great frequency. However, only a fewinduce large changes in prices immediately or cumulatively over
CHAPTER 1 • INTRODUCTION
27
time. Most daily changes in financial market prices are relativelysmall in percentage terms. Thus, large percentage price moves are ofinterest because they are both less common and because they tell ussomething about the process that generates changes in prices.It would be wrong to think of traders as waiting for a trading catalyst to occur before responding to it by taking positions. To be sure,large price moves are often accompanied by large trading volumes.However, as explained in the next chapter, knowledge of market conditions and sentiment bias can create the conditions where the market can be subject to all manner of potential trading catalysts. Simplystated, a trader can react to a trading catalyst after it occurs or anticipate the market’s reaction prior to the occurrence of the catalyst orcatalysts and position herself accordingly.Trading catalysts can affect the short-term liquidity of the market,as was shown by the dramatic impact the Fed rate cut had on theeffective Nasdaq 100 stock index futures bid/ask spread on January 3,2001. An increase in volatility may also be considered a trading catalyst by stimulating trading volume. It is also a factor that is internal tothe market. Increased volatility leads to increased demand for vehicles to hedge the volatility. The additional trading may also createmore short-term trading opportunities.As will be discussed in more detail in later chapters, the market’sreaction to a trading catalyst need not be consistent over time. Sometimes, the market focuses on one potential trading catalyst to theexclusion of other trading catalysts that might be announced at thesame time. It seems that the market acts as if it has a one-track mind.Sometimes, it is not clear what the market really reacts to.The price changes that trading catalysts induce are often transitory. This means that a trader seeking to position himself in advanceof a potential trading catalyst will have to determine the appropriatetime horizon for any prospective trade. Strong money managementrules might keep a trader in a profitable position longer than thetrader anticipated when he entered the trade. However, the trader is
28
TRADING CATALYSTS
still subject to the risk of a sudden price reversal before the traderexits his position. For example, a trader who entered a buy order forthe Nasdaq futures contract a few minutes late and was filled at 2650on January 3, 2001 would find that he bought at the high of the day. Allof this makes trading off of trading catalysts both difficult and risky.
ReferencesAllais, Maurice. “Forgetfulness and Interest.” Journal of Money,Credit and Banking. Vol. 4, Issue 1, February 1972, pp. 40-73.Bahree, Bhusan, and Chip Cummins. “Energy-Price VolatilityReturns Due to Output Outages, Weather,” The Wall Street Journal.January 11, 2005, p. C5.Brown, John Dennis. 101 Years on Wall Street: An Investor’s Almanac. New York: Prentice Hall, 1991.Clausewitz, Carl von. On War. Edited and translated into English byMichael Howard and Peter Paret. Princeton: Princeton UniversityPress, Revised edition, 1984.Fama, Eugene F. “Efficient Capital Markets: A Review of Theory andEmpirical Work.” Journal of Finance, XXV, No. 2, May 1970, pp. 383417.Federal Reserve Board of Governors Web Site (http://www.federalreserve.gov/boarddocs/press/general/2001/20010103/default.htm), Federal Open Market Committee Press Release, January 3,2001.Francis, Jack C., and Roger Ibbotson. Investments: A Global Perspective. Upper Saddle River, New Jersey: Prentice Hall, 2002.Jackwerth, Jens C., and M. Rubinstein. “Recovering Probability Distributions from Option Prices.” Journal of Finance, December 1996, pp.1611-1631.
CHAPTER 1 • INTRODUCTION
29
Keynes, John Maynard. The General Theory of Employment, Interestand Money. New York: Harcourt, Brace and World, 1935.Morgan, Michael. “Crude Price Dip Boosts Stocks.” Financial Times,October 28, 2004, p. 28.Roberts, Harry. “Stock Market ‘Patterns’ and Financial Analysis:Methodological Suggestions.” Journal of Finance, Vol. 12, No. 1,March 1959, pp. 1-10.Schwager, Jack D. Market Wizards: Interviews with Top Traders.New York: New York Institute of Finance, 1989.Waters, Richard. “ebay Shares Fall by 11% as Earnings Falter.”Financial Times, January 20, 2005, p. 15.
Endnotes1
Carl von Clausewitz, On War.
2
The announcement was released at approximately 1:14 P.M. Eastern StandardTime. An examination of the wording of the announcement is interesting forwhat it says and what it does not say. The text of the announcement follows:The Federal Open Market Committee decided today to lower its targetfor the federal funds rate by 50 basis points to 6 percent. In a relatedaction, the Board of Governors approved a 25-basis-point decrease inthe discount rate to 5-3/4 percent, the level requested by seven ReserveBanks. The Board also indicated that it stands ready to approve a furtherreduction of 25 basis points in the discount rate to 5-1/2 percent on therequests of Federal Reserve Banks.These actions were taken in light of further weakening of sales and production, and in the context of lower consumer confidence, tight conditions in some segments of financial markets, and high energy pricessapping household and business purchasing power. Moreover, inflationpressures remain contained. Nonetheless, to date there is little evidenceto suggest that longer-term advances in technology and associated gainsin productivity are abating. The Committee continues to believe that,against the background of its long-run goals of price stability and sustainable economic growth and of the information currently available, therisks are weighted mainly toward conditions that may generate economic weakness in the foreseeable future. In taking the discount rateaction, the Federal Reserve Board approved requests submitted by theBoards of Directors of the Federal Reserve Banks of New York, Cleveland, Atlanta, St. Louis, Kansas City, Dallas and San Francisco.
30
TRADING CATALYSTS
3
The Nasdaq 100 index consists of the 100 largest nonfinancial companies interms of market capitalization listed on Nasdaq, whereas the Nasdaq Compositereflects almost every firm traded on Nasdaq. Tracking stocks allow market participants to trade an index just like they would an individual stock.
4
Stock index futures contracts allow market participants to bet on the future valueof the index.
5
This is not the case for some agricultural commodities. Another exception to thisrule occurs during rollover periods when the trading volume of the futures contract that is the second closest to expiration exceeds the trading volume of thecontract that is closest to expiration. Essentially, the second closest to expirationcontract displaces the closest to expiration futures contract as the effective frontmonth contract. The front month contract is not the futures contract that is closest to expiration for some commodities like Eurodollar futures.
6
The notional or dollar value of the Nasdaq 100 futures contract is $100 times theNasdaq 100 index value. Thus, an index value of 2000 would imply that thefutures contract had a notional value of $200,000. In other words, one Nasdaq100 stock index futures contract would be equivalent to buying a $200,000 diversified portfolio of Nasdaq stocks whose performance mirrors the Nasdaq 100index. The minimum price move, or tick, on the contract is .50 point. Each tickhas a value of $50 ($100 times .50).
7
As John Dennis Brown points out in his book, 101 Years on Wall Street, the highon the DJIA for 1929 was reached on September 3, 1929 when it hit 381.17. Itshould also be noted that the stock market had declined significantly from thehigh before the crash occurred in late October of 1929.
8
Jack C. Francis and Roger Ibbotson. Investments: A Global Perspective. UpperSaddle River, New Jersey: Prentice Hall, 2002, p. 25. Francis and Ibbotsonreport that the compound annual return for large company and small companystocks over the same period was 11.3% and 12.6%, respectively.
9
The Nasdaq 100 stock index futures contract settled at 2529.50 or 362 pointshigher than the previous day. The spot Nasdaq 100 index closed at 2528.38 or399.60 points higher for the day. The Chicago Mercantile Exchange also lists anelectronically traded version of the Nasdaq 100 stock index futures contract thatis one-fifth the size of the pit-traded Nasdaq 100 stock index futures contract. Itmight be argued that the behavior of the e-mini futures prices were more representative of the market’s reaction to the Fed rate cut trading catalyst. However,such an argument ignores the fact that the daily price change was essentially thesame for both contracts. Moreover, the pit-traded Nasdaq 100 contract exceededthe trading volume of the Nasdaq e-mini futures contract on a size-adjustedbasis. Note that the pit-traded volume was 35,677 contracts on January 3, 2001,virtually all of which were March 2001 futures contracts. The Nasdaq e-minifutures contract had record trading volume of 115,139 contracts on January 3,2001, virtually all in the March 2001 contract.
10
Marketplace. January 3, 2001.
CHAPTER 1 • INTRODUCTION
31
11
These and most other figures in this book are presented in Japanese Candlesticks format, where open, high, low, and close data are used to construct simplebar charts.
12
The trader would also be interested in the position size that he could put on andthe expected slippage associated with the prospective trade. Slippage measuresthe difference between the price at which the trader can actually execute thetrade at and the price quote he observes when he submits the trade.
13
Expectations of the future are often a function of individual past experiences orperceptions of the past experiences of others. To the extent that memory plays arole in formulating expectations of the future, the question arises as to how individuals weight past observations in formulating expectations about the future.Put differently, what is the rate of forgetfulness of individuals? This is not merelya function of calendar time. Nobel Laureate economist Maurice Allais discussesthe rate of forgetfulness and argues that individuals form expectationsadaptively.
14
Bhusan Bahree and Chip Cummins. “Energy-Price Volatility Returns Due toOutput Outages, Weather.” The Wall Street Journal, January 11, 2005, p. C5.
15
Michael Morgan. “Crude Prices Dip Boosts Stocks.” Financial Times, Thursday,October 24, 2004, p. 28.
16
Positive feedback trading refers to cases where a rise in prices spurs additionalbuying, which drives up prices even further, and a fall in prices spurs additionalselling, which drives prices down lower.
17
John Dennis Brown. 101 Years on Wall Street: An Investor’s Almanac. New York:Prentice Hall, 1991.
18
Of course, this assumes that Brown’s classification is correct. It is possible thatother observers would identify other trading catalysts associated with the largepercentage price changes on those days.
19
An exception is changes in the value of default free discount securities (e.g.,Treasury bills), which increase in value as time passes if the interest rate remainsthe same or lower.
20
Eugene F. Fama. “Efficient Capital Markets: A Review of Theory and EmpiricalWork.” Journal of Finance, XXV, No. 2, May 1970, pp. 383-417.
21
Proponents of market efficiency argue that the observation of individualswho consistently beat the market is simply a product of chance. Proponents ofmarket inefficiency argue that such observations are evidence that the market isinefficient.
22
In a fascinating article, Jens C. Jackwerth and Mark Rubinstein use option pricesto ascertain the relevant (risk-neutral) probability distribution that U.S. stockmarket participants face. They argue that large one-day returns of the magnitudeearned or lost on the stock market crash of October 1987, for example, would bevirtually impossible if security returns were lognormally distributed. They state(on pages 1611 and 1612):On October 19, 1987, the two month S&P 500 futures price fell 29 percent. Under the lognormal hypothesis, this is a -27 standard deviation
32
TRADING CATALYSTSevent with probability 10160, which is virtually impossible. Nor is October 1987 a unique refutation of the lognormal hypothesis. Two yearslater, on October 13, 1989, the S&P 500 index fell about 6 percent, a -5standard deviation event. Under the maintained hypothesis [of lognormality], this has a probability of 0.00000027 and should occur only oncein every 14,756 years.The fact that extreme price moves occur with greater frequency means that therelevant return distribution for traders and investors has fatter tails than a normal distribution does. J.C. Jackwerth and M. Rubinstein, Journal of Finance,1996, “Recovering Probability Distributions from Option Prices,” pp. 16111631.
23
John Maynard Keynes. The General Theory of Employment, Interest and Prices.1935, p. 156.
24
Jack Schwager [1989] reports Richard Dennis’ response to his question, “What isthe biggest public fallacy about market behavior?” as “That markets are supposed to make sense” (p. 106).
2MARKET CONDITIONSAND SENTIMENT
“Water shapes its course according to the nature of theground over which it flows; the soldier works out his victoryin relation to the foe whom he is facing. Therefore, just aswater retains no constant shape, so in warfare there are noconstant conditions.”—Sun Tzu1
Treasury Announcement DiscontinuingIssuance of 30-Year BondsAt approximately 9:50 A.M. on Wednesday, October 31, 2001, the U.S.Treasury announced that the 30-year Treasury (or long) bond wouldno longer be issued. The immediate reaction of Treasury bond pricesdid not reflect the significance of the announcement, in large part,
33
34
TRADING CATALYSTS
because the announcement came from the inadvertent and premature posting of the text of then Treasury Undersecretary PeterFisher’s remarks on the department’s Web site about 10 minutesbefore the news embargo was to be lifted. As a result, the long bondrose modestly at first, from about 102 27/64 at 9:50:09 to 103 1/32 at9:55:33. However, prices quickly gathered steam as word of theannouncement spread. Prices had risen to 104 1/32 by 10:00, the timeof the scheduled announcement. This full-point move was only thebeginning as the news set off a firestorm of panic buying. Prices rallied over the next 21 minutes or so, before falling back only to rallyagain to over 108 shortly after 1:00 P.M. The long bond was up over 51/4 points by the end of the day, and the yield had fallen by 34 basispoints.2 This is a huge move in the Treasury bond market. Indeed, theTreasury announcement sparked the largest one-day rally in Treasurybond prices since the October 19, 1987 stock market crash.The rally did not end on Wednesday. On Thursday, November 1,2001, the “long bond” rallied to a high of 111 13/32, or almost 3 3/4points above the previous day’s close, before pulling back and closingat 108 31/32. Market talk attributed the continuing rally on Thursdayto the Treasury announcement the previous day and the actions ofinstitutional investors in response to it. The massive rally in Treasurybond prices following the Treasury Department’s announcement isdepicted in Figure 2.1.
CHAPTER 2 • MARKET CONDITIONS AND SENTIMENT
112.00111.00
10/31/2001Treasury announcement
110.00
10/31/2001date.open 102.5625date.high 108.5313date.low 102.0625date.close 107.7813
109.00108.00107.00106.00105.00104.00103.00102.00101.00100.0099.0098.0097.0096.0095.008/1/01
9/1/01
10/1/01
11/1/01
12/1/01
1/1/02
Reaction of the 30-year U.S. Treasury bond to the October 31, 2001 Treasury announcement suspending issuance of new long bonds. Daily trading rangeof the cash market 30-year Treasury bond from August 1, 2001 to January 15, 2002.
FIGURE 2.1
The Treasury suspends issuance of the long bond.35
36
TRADING CATALYSTS
Note that contrary to what the efficient market hypothesis wouldpredict, the bond market took a long time to digest the news of theTreasury decision. First, the market did not react fully to the inadvertent and premature posting of the announcement on the TreasuryDepartment’s Web site on Wednesday. Second, the market continuedto react to the news throughout the rest of the trading day. Third, theTreasury bond market had an intraday move on Thursday, November1, 2001 that was approximately half the size of the previous day’smove when the news came out. The lack of other news suggests thatthe Treasury bond market was responding to either the previous day’snews or the Treasury market’s reaction to the previous day’s news.Fourth, Thursday’s market move was not all in one direction. Afterrallying another 3 3/4 points on Thursday, the market gave up almost2 1/2 points—a significant correction. This suggests that the marketoverreacted to the Treasury announcement. Once again, there wasplenty of time for traders to trade off of the news.Where should a trader have placed her bets upon learning of theTreasury announcement? A trader learning of the news on the Treasury Web site prior to 10:00 A.M. might have been tempted to buyDecember 2001 Treasury bond futures contracts traded on theChicago Board of Trade (CBOT) instead of buying Treasury bonds inthe cash market. The Treasury bond futures market is deep and liquidand often leads the corresponding cash market. Traders can easily dosize without significantly affecting transaction prices.
CHAPTER 2 • MARKET CONDITIONS AND SENTIMENT
37
However, such a decision would have been a mistake as Figure2.2 shows. The reason is that the strong reaction in the cash Treasurybond market was largely absent in the Treasury bond futures markets.An examination of time and sales data for the December 2001 Treasury bond futures contracts reveals that the futures price was at 10821/32 at 9:50:12 A.M., shortly before the announcement was posted onthe Web, and settled at 110 14/32 by the end of the day. Although thealmost 1 3/4 point move would have resulted in a substantial profit,the profit pales in comparison to what a trader could have made giventhe almost 5 1/4 point move in the cash bond market. Anticipating themarket’s reaction to news is important, but it is also important to position oneself in the right market in order to maximize profits.Why was there a substantially different reaction in Treasury bondcash and futures market prices? The principal explanation for thisseeming anomaly is that the CBOT Treasury bond futures contractallows delivery of a whole array of Treasury bonds on the contractrather than just Treasury bonds that mature in 30 years.3 Because theindividual who is short Treasury bond futures has the option of choosing which Treasury bonds to deliver (and the rational short almostinvariably chooses the cheapest bond), the Treasury bond futurescontract tracks the cheapest-to-deliver Treasury bond. This is rarely, ifever, the on-the-run (i.e., most recently issued) 30-year Treasurybond. Consequently, buying the December 2001 Treasury bondfutures contract on October 31, 2001 was tantamount to being longthe cheapest-to-deliver Treasury bond on a day when news impactedlonger maturity Treasury bonds much more than the cheapest-todeliver Treasury bond. Not surprisingly, the 30-year Treasury bondfutures contract did not rally as much as the cash 30-year Treasurybond did.
38
113.00112.0010/31/2001date.open 108.4688date.high 111.3125date.low 108.2188date.close 110.4375
111.00110.0010/31/2001Treasury announcement
109.00108.00107.00106.00105.00104.00103.00102.00101.00100.0099.00
8/1/01
9/1/01
10/1/01
11/1/01
12/1/01
1/1/02
Reaction of CBOT Treasury bond futures prices to October 31, 2001 Treasury announcement suspending issuance of the long bond. Daily trading range offirst month CBOT Treasury bond futures prices from August 1, 2001 to January 15, 2002.
FIGURE 2.2
Treasury bond futures prices react.
TRADING CATALYSTS
98.00
CHAPTER 2 • MARKET CONDITIONS AND SENTIMENT
39
The market’s reaction to the Treasury announcement on Wednesday, October 31 is further complicated by the subsequent discoverythat a bond trading consultant (whom Treasury officials had thoughtwas simply another reporter) had sat in on the Treasury’s quarterlyrefunding press briefing and, in violation of the news embargo until10:00 A.M., had conveyed the information to individuals at a majorinvestment bank and a fixed income management firm shortly afterthe Treasury Department’s press conference ended at 9:25 A.M.4 Thismeant that news of the Treasury’s impending action was known by atleast two major bond market participants well in advance of the actualannouncement. This knowledge enabled the recipients of the information to take positions in the Treasury bond cash and futures markets that would benefit when the information became publiclyavailable. This is insider trading and is illegal in the United States.Insider trading in the Treasury bond market is a rare event, inlarge part, because there is little information that is truly inside. Certain Treasury Department debt-management decisions and FederalReserve monetary policy actions are exceptions. The details of thepresent case provide fascinating insights into insider trading ahead ofa major trading catalyst and warrant close examination.The Securities and Exchange Commission (SEC) announcedenforcement actions on September 4, 2003 against some of the partiesinvolved in the misappropriation of, and trading on, inside informationinvolving the Treasury’s decision to cease issuance of the long bond.Essentially, the Securities and Exchange Commission alleged thatPeter Davis—a Washington D.C. based consultant—…attended the Treasury Department’s quarterly refundingpress conference on the morning of Oct. 31, 2001, where helearned of the Treasury’s decision to cease issuance of the30-year bond…Davis called numerous clients and tippedthem to news about the cancellation of the long bond beforethe Treasury Department’s news embargo was lifted and thenews was made generally available to the public. John M.
40
TRADING CATALYSTS
Youngdahl,…formerly a Vice President and Senior Economistat Goldman Sachs & Co., [entered into an agreement withDavis in July 2001 whereby] Davis would provide Youngdahlwith confidential information he learned at Treasury Department refunding press conferences…[A]fter receiving Davis’scall on the morning of Oct. 31, 2001, Youngdahl tipped traderson Goldman Sachs’ U.S. Treasury Desk to the news about theTreasury’s decision to cease issuance of the long bond. Whilethe news was still nonpublic, the traders purchased $84 million worth of 30-year bonds for Goldman Sachs’ ownaccounts, generating illegal profits of over $1.5 million…5In a related announcement, SEC staff indicated that GoldmanSachs made $2.3 million from purchasing 2336 CBOT Treasury bondfutures contracts after learning of the Treasury’s impending action.6Goldman’s Treasury bond futures position had a notional value of$233.6 million, or slightly less than three times the size of the cashmarket position it took. Interestingly, Goldman did not maximize itspotential profits from trading off of the advance information of theTreasury’s announcement because it chose to trade mostly Treasurybond futures contracts.7The Treasury Department’s announcement to discontinue 30-yearTreasury bonds induced an exceptionally powerful rally that lasted thebetter part of two days before subsiding. What made this trading catalyst so powerful and long-lasting? Was it the nature of the announcement or its timing, or did other factors play a significant role?
Market Conditions, Sentiment, andTrading CatalystsAs noted in the previous chapter, traders form trading theses abouthow financial and commodity markets should react to potential trading catalysts. However, the power of a statement, action, or event toserve as a trading catalyst is intimately intertwined with the market
CHAPTER 2 • MARKET CONDITIONS AND SENTIMENT
41
conditions and sentiment bias that prevail at any moment of time.Market conditions and sentiment bias can exacerbate a price move,mitigate it, change the direction of the reaction in prices from previous reactions to similar events, cause an otherwise potentially significant trading catalyst to be seemingly ignored by the market, or insome cases, even induce a significant change in prices to the occurrence of widely anticipated events. Market conditions and sentimentbias can also affect the duration of the impact of trading catalysts onmarket prices.Markets are sometimes characterized by fads where a particularsector (e.g., biotech stocks) is considered hot. Less common areextreme market events such as bubbles, crashes, or crises. Fads andextreme market events have a dynamic all their own and not onlyinfluence the potential power of trading catalysts on market pricesbut also impact the set of potential trading catalysts. The interrelationship between trading catalysts and extreme market events isconsidered in Chapter 9, “Bubbles, Crashes, Corners, and MarketCrises.” This chapter focuses on the impact of market conditions andsentiment bias on the power of trading catalysts during more normalmarket conditions.Market conditions refer to the underlying economic situation, policy regime, political environment, risk preference level, and tradingenvironment that prevail at a given moment in time. Traders mustassess a variety of factors to obtain a sense of market conditions. Thistask is made more difficult because some factors (e.g., the strength ofthe economy) may also depend upon other factors (e.g., monetarypolicy). It would be wrong to give the impression that traders are interested in making detailed assessments of the economy and politics.Rather, traders are trying to answer some recurring basic questions inorder to improve their trading performance. For instance, is the economy expanding or contracting? Is central bank monetary policy accommodative or restrictive? Is the average level of risk aversion amongmarket participants high or low? Is the market tranquil or turbulent,
42
TRADING CATALYSTS
choppy or normal, liquid or illiquid, overbought or oversold? Are thereconcentrated trading positions in one direction by key market participants? Can one trade in size without unduly affecting market prices?These are only some of many potential market conditions. Some market conditions may also act as internal market catalysts.Sentiment is a measure of the collective market bias of traders andother market participants—that is, market sentiment is a way of characterizing whether a given market overall has a bullish or bearish biaswith respect to likely future price action and the extent of the bias. Ofcourse, not every market participant shares the same point of view ormarket bias at any moment in time. After all, differences of opinionsmake markets. Sentiment bias can reinforce or retard a price move atrading catalyst precipitates. It can also exacerb