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Trading on the News to Predict Market Behavior

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Associate Professor Anna Scherbina studies investment management, capital markets, behavioral finance, and empirical asset pricing. In this blog, she discusses practical implications for her recent research regarding trading on the news.

It shouldn’t be surprising to anyone that news affects stock market prices. A company comes out with a new product, announces expansion into new markets, or reports financial losses for a certain quarter. This kind of information undoubtedly affects the way investors trade, but to what extent?  My latest study, co-authored with Andreas Neuhierl and Bernd Schlusche, “Market Reaction to Corporate Press Releases” explores this very issue. Our findings can provide investors a leg up in the market by providing more insight on how to interpret market behavior and invest more wisely.

Recently, a regulation was passed mandating that corporations publically release all news that might affect their valuation, which is what corporations now do, typically in the form of corporate press releases. This is great news for investors in general. Why? Because prior to this regulation corporations were only required to release news to financial managers and investment analysts, not to everyone. For the first time, the public has unprecedented access to news that could provide insight into market reactions in real time.

My co-authors and I took advantage of this situation by collecting and categorizing the news releases, keeping an eye on content that affected investment value.

Of course, the key thing to examine is the immediate price reaction.  Knowing the history of price reaction to specific types of news, investors can improve their ability to predict market reaction and trade more effectively on the news.

Yet some news may be ambiguous and not lead to an immediate price reaction.  High trading volume following an announcement may indicate that investors disagree about the impact of the news. High level of investor uncertainty about the resulting valuation will lead to low liquidity, because traders will be concerned that someone else knows more about the stock price than they do.  Hence, it is also crucial to study the impact of news on the informational environment of the firm. When informational uncertainty increases, price becomes tenuous, and thus reacts more strongly to subsequent news releases, increasing subsequent price volatility.  Hence, investigating changes in trading volume, liquidity and volatility subsequent to news releases offers another important angle in exploring the impact of news announcements.

Our findings confirmed earlier studies about what the price reaction should be for different types of news, and identified price reactions to the types of news that previously received little attention due to lack of data.  We also confirmed that some news have the potential to significantly alter the information environment of the firm.  In particular, we confirmed that news stories using keywords like “groundbreaking” or “unprecedented” signaled to investors that the content was out of the ordinary, and typically led to significant increases in subsequent stock volatility. In short, the market knows how to react to routine news, but has difficulty interpreting the impact of less routine news.

Takeaways for Investment Professionals

Investment professionals can potentially trade on the news, but it’s not easy because they have to apply a strategy of quick turnover. The reason for this is that the price reaction to news releases is very quick so they need to stay on their toes. One way to manage the process is to create an algorithm where investors scan various newswires, pull out press releases and identify content based on keywords. However, it might be difficult to  identify whether news is positive or negative by using standard linguistic analysis, because more often than not, bad news is framed in a positive way.

For example, there’s now a new set of linguistics applied to news where companies such as Reuters or Dow Jones try to classify news based on content analysis. These news agencies identify negative and positive keywords to interpret the content. However, the cautionary note is that this approach can be misleading. One great example is that sometimes when a corporation’s stock is overpriced, the company will issue equity, to take advantage of the overvaluation. To an outsider, it’s not apparent that something’s wrong because the press release doesn’t contain negative keywords.  This kind of behavior signals that the stock might be overpriced. So what works for investors?  In order to get more precise news classifications, they would have to analyze the content of the news, in addition to how it is being presented.

UC Davis Executive Education highlights the research of key faculty members in the Graduate School of Management, interpreting their findings and teasing out the practical takeaways for leaders and professionals. For more information on Executive Education at UC Davis, please contact Managing Director Wendy Beecham.

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