Risk management is a trader’s best friend, and when it comes to event trading, it is his soul mate. Disasters typically happen unexpectedly: earthquakes, weather scares, political unrest and terrorist strikes, such as September 11, 2001. Some events have warnings, typically weather that can affect crops or pipelines, such as tornados, hurricanes, floods or drought. Some events are expected but not to the degree that they happen: Fed rate cuts. But no matter which type of news, a trader should always have a plan.
In this issue we have two long-time traders and educators providing insights on how to trade markets, either purposely looking for news, such as corporate events that causes stock drops or rises, or surprise announcements from the government. Tom Busby discusses “Five keys to surviving the news,” (page 42), while Larry McMillan shows how using options can protect you in many ways in “Event trading with options,” (page 38).
These stories are timely, especially with the Federal Reserve’s September rate cut. Despite the turmoil going on in the credit market and the Street’s belief the Fed would come through, the 50-basis point cut was a surprise, albeit a pleasant one to many.
Another surprise can be how markets respond to news: the recent admission by Citigroup and UBS on their credit losses sent the stock markets soaring to new highs. Does this make sense? In a strange way, yes: the market was expecting the news, and now that it was out in the open, all was right with the world again. Of course, typically you would think bad news, such as write offs, would hurt the stock market. Well, as they say in football, that’s why they play the game.
Today every market is exploding, and even if you aren’t an event trader, learning how to protect yourself is your best defense. Busby believes in stop-loss orders, which many traders eschew. The reason some don’t like them is in a choppy market, a trader can get kicked out of a market only to see it turn around and head in the trader’s direction. As Mae West said, the story is so old it should have been put to music long ago. But Busby isn’t saying put in a tight stop, but determine how much risk you can handle in some worst case scenarios and set the stop. Prudent advice.
He tells a story that on 9/11 he had been teaching a class and they were long the S&P 500. Luckily, they had on protective stops, because even though they weren’t watching the news, by the action in the markets, they knew something had happened. Sure enough because they had the stop orders in, that devastating day didn’t become even worse on a personal finance level.
McMillan discusses how to utilize options to actually take advantage of surprise news, especially with corporate earnings announcements. Some strategies work better than others, obviously. He notes that selling straddles into earnings announcements isn’t a good idea because, well, the news may take an unexpected turn. “The risks of the unknown are just too high,” he states and selling straddles is too much exposure in these unsure times.
Of course, there are times selling options may be the acceptable, as James Cordier and Michael Gross outline in “Naked but not overexposed,” (page 46). These options selling specialists show how those who would sell options can prevent the wipeout effect that could happen in a surprise move. Many options sellers have met their financial end by not taking precautions. Here are some ways to stay ahead of the game.
News that affects markets can come from unlikely events and sources. And as many times as traders are told to manage their risk, a freak event can cause havoc. Just like buying car insurance, you’re hoping you never need to use it but it’s comforting knowing you have it.
