How News Affects the Movement of Financial Markets

In order to be a successful trader it is essential to understand market psychology and be able to anticipate in a relatively timely manner when the overriding psychology in the market has changed. The reason for this being that the movement of price in financial markets is the result of these changes in psychology. While each individual investor's psychology is influenced by a different set of criteria, there are certain things that can influence a large number of traders simultaneously. One of these things is economic announcements. Economic announcements for the purpose of this article, are meant to include things such interest rate decisions by the Federal Reserve, economic data reports (i.e. GDP, unemployment, CPI, housing sales etc..), and earnings reports, or in other words are announcements related to the economy or an individual company that have a specified release date and time. While there is a huge variety of data reported in relation to the economy everyday, there are certain announcements which garner much more attention than others, and as such can shift the psychology of market participants in such a drastic manner as to sharply alter the underlying market trend. Due to the powerful role that these announcements can have on the markets it can be very beneficial for a trader to attempt to understand how the announcements will likely affect the psychology of traders as in doing so one can obtain a powerful edge to help increase the probability of executing profitable trades. However, one must understand that the effect that these economic announcements have on the markets is not as simple as if the news is good prices will rise and if the news is bad prices will fall, instead the effects are not surprisingly, much more complex.

A major economic announcement such as the release of GDP growth rates, employment figures, or an earnings report for a major company can affect the market in three general ways: Firstly, it can cause the overriding market psychology to change, leading to a change in the direction of the market trend. Secondly, it can accelerate the pace of the existing trend by increasing the already existent bullishness or bearishness of market participants. Or thirdly, the announcement can have little effect on the psychology of market participants and subsequently have little impact on price movement. If an investor is able to determine which of these three scenarios is most likely to occur following the announcement they can adjust their trading strategy accordingly as not to be caught on the wrong side of a move or be surprised by a sudden increase in volatility. In order for a trader to determine what effect the announcement will likely have on the market there are two main things that must be determined and they are; the consensus or expectation among market participants in relation to the announcement, and secondly, the underlying trend in the market.

The consensus or expectation for an announcement can easily be found on various financial websites (for example on Bloomberg) and is important when attempting to interpret the effect that an economic announcement will have on the market because of the fact that markets are forward looking, meaning that they discount information once it becomes available. So for example if a company, such as IBM, has an earnings release and the projected consensus earnings per share (EPS) are $1.70, if IBM meets expectations then the likely effect of this earnings release on the price of IBM will in most cases be relatively minimal because of the fact that this information has already been discounted into the price by market participants. In other words, when economic announcements meet the consensus projections the effect that they have on the psychology of market participants is usually relatively limited. However, the same cannot be said about economic announcements which surprise investors with numbers that are far from the projected or consensus levels, as announcements of this manner can produce sharp and often drastic changes in market psychology. The reason for this is easy to see; if the majority of market participants all factor into their trading decisions that the release of let's say monthly GDP numbers for example, are going to be near a certain consensus level, but the actual release ends up being well above or below expectations then this will in many cases shock investors causing a change in their market outlook. The nature of financial markets in terms of the speed at which they operate can further amplify changes in price due to surprising reports because of the effect that emotions have on the movement of price. Emotions are one of the primary drivers of price trends and in many cases are solely responsible for driving prices to extreme levels due to the rash decisions that traders often make when influenced by fear and greed. As such, a surprising economic or earnings report especially when the consensus projections are far off target can quickly increase the role that emotions play on traders' buying and selling decisions. For example in the case of a missed GDP report to the downside, those traders who were long will in many cases become fearful that their assumptions or reasons for buying were incorrect and in many cases this fear will lead them to sell their contracts increasing supply and driving down prices. Falling prices can further add to the fear of other market participants who may not have been as affected by the initial release, but seeing price fall will often cause them to also succumb to their emotions (in this case fear) which will lead to a further increase in supply and greater downward pressure on price. What this all means is that while it is important for investors to pay attention to the major economic and earnings reports, in most cases it is only the announcements which surprise investors that are likely to have much of a noticeable effect on the movement of price.

Being aware of what the consensus projections are for the major economic or earnings reports can help an investor be prepared to interpret what affect the actual release may have on the market. However, one can be even more prepared if they are also aware of the underlying trend in the market, be it an uptrend, a downtrend, or a consolidation (sideways trend), as well as the strength or momentum behind the trend. This is helpful in determining how economic announcements will affect the market as reports that are in agreement with the underlying trend (for example if the trend is bullish and the report is also bullish) have a different effect then reports that are counter to the underlying trend (for example trend is bullish and report is bearish). When the report is in agreement with the underlying trend in the market, this will confirm the majority of investors’ beliefs leading to a continuation and possible acceleration in the trend. However, as was mentioned earlier it is times when reports surprise investors that they have the greatest effect on the markets, and this can certainly be seen when reports surprise investors but are still in line with the underlying trend. In other words, if the market is experiencing a strong bear market and the announcement misses consensus expectations to the downside (for example EPS are $0.50 instead of the consensus $1), then the momentum or strength behind the trend will often accelerate dramatically leading to substantial and rapid declines in price. (The opposite will occur for surprisingly bullish announcements in a bull market.) The reason for this again goes back to the primary driver of price, market psychology, as when a report comes out which surprises investors but is in line with the underlying trend, this will strengthen investors' beliefs or in other cases shift more investors in line with the current trend. A good analogy of the effect that surprise reports in agreement with the underlying trend have on the movement of price is that it is like pushing a car that is already rolling down a hill, the report provides the extra strength to accelerate the move, and as happens so often in the markets, moves that start to accelerate lead to elevated emotional levels in investors with fear and greed increasing and often driving prices to extreme levels. Understanding the effect that economic announcements have on the movement of price when the report is in agreement with the underlying trend can help a trader determine whether they should lock in profits or allow the winners to run.

Another situation which can have a significant effect on price movement in relation to economic announcements is when the report is counter to, or in disagreement with the underlying trend. In these cases it is difficult to predict how the market will react as the effect on the psychology of individual traders can vary quite significantly. However, there are a few guidelines that can allow a trader to more accurately narrow down the likely impact that the report will have on price movement. In order to do this it is important to determine the relative strength of the trend as when a market trend is extremely strong, in many cases a report that only misses the consensus expectations by a small amount counter to the direction of the trend (i.e., the trend is bullish and the report is slightly more bearish then expected) will be brushed off or ignored by market participants because of the strength of the prevailing market psychology. In these cases their may be a slight pause in the trend, but overall the trend will continue in its original direction. However, when a report misses expectations by a more significant amount (again counter to the trend) this will affect the psychology of market participants in a more significant manner. Some traders will become fearful that this report is signaling a changing economy while others may see it as just an aberration believing that the bullish or bearish trend is likely to continue. In these cases the divergent beliefs among traders can produce significant volatility in the markets, with one group of traders believing the trend will continue and another group of traders fearful that trend is over. During times like this it is often beneficial to stay on the sidelines until the market reveals which group of traders has been proven correct as markets experiencing high levels of volatility are notoriously challenging to trade. Finally, situations which see the report miss consensus expectations by a very large degree and counter to the prevailing trend, while rare, will often shock most traders and as a result can lead to a quick and dramatic reversal in the trend. For example if a monthly GDP report has a consensus expectation of a 1% growth rate and the underlying market trend is bullish, but instead the actual report reveals a contraction in the economy of -0.3%, traders will quickly become fearful that there has been a dramatic change in the economy which they were unprepared for. Due to the fact that this type of report surprises the overwhelming majority of investors in many cases an individual's trading decisions become more influenced by emotions (realizing their expectations were far off base) then rational thought and these circumstances can see markets move significant and sometimes astonishing amounts in short periods of time. That being said traders should be aware that often following a sharp price move markets will then see sideways movement or increased levels of volatility as traders try to sort out what the long term implication of the new information will be and it is during these times that it can be beneficial to lock in some profits.

The third type of trend which has not yet been discussed and in some cases can provide excellent trading opportunities following significant economic announcements is the sideways trend or in other words the consolidation. A consolidating market is one that experiences net sideways movement over an extended period and is usually bounded by an upper level or resistance and a lower level of support. In many cases when a significant economic or earnings report is about to be released and market participant vary widely in their beliefs of what the announcement will bring, the market will trend sideways and in many cases see a narrowing range as the release becomes more imminent. This type of situation is very often seen preceding a rate decision by the Federal Reserve, if one looks at a Dow Jones Industrial Average or S&P 500 intra-day price chart on the days that the Fed is set to announce a rate decision they will see just how little the market actually moves leading up to the 14:15 announcement. However, following the release the market will in many cases break sharply out of the range in one direction or another. Again the size and sustainability of the breakout from the consolidation depends on the underlying sentiment (bullish, bearish, or neutral) and the degree to which the announcement surprises investors or confirms their prior beliefs. While situations where the market consolidates before an announcement can lead to significant directional price moves and as such good trading opportunities, one must also be wary of the associated volatility which is also experienced in these situations. In order to determine whether a breakout is truly sustainable and not just resulting from a spike in volatility a trader must determine whether the underlying market psychology following the announcement has aligned strongly in one direction or if it is full of conflicting views and uncertainty. Uncertainty and confusion in a market produces high levels of volatility and in many cases extended sideways movement as neither the bulls nor the bears have the confidence to push price significantly up or down creating a difficult trading environment.

To conclude, economic announcements such as rate cut decisions, GDP reports, inflation reports, and earnings reports, among others, can lead to significant moves in price and as such good trading opportunities. However, this is definitely not the case with every announcement. In certain situations an announcement will produce significant levels of volatility, while at other times an announcement may have an extremely minimal effect on the psychology of market participants. As such it is important for traders to learn to interpret what effect the announcement may have on the movement of price in order to exit positions at times when it looks as though the market may be reversing, to enter trades or stay in existing positions when price looks to be breaking out in one direction, or finally to remain on the sidelines when the announcement is likely to produce high levels of volatility in the market. While it is extremely difficult for an investor to consistently predict the effect that the announcement will have on the market before hand, a trader can increase their probability of executing correct trading decisions after the announcement by being aware of the general expectations with respect to the announcement as well as being aware of the underlying trend and its associated strength. Finally, one must realize that being able to interpret the impact that economic announcements have on the movement of financial markets is not the Holy Grail of trading. The market is a complex dynamic system and as such consistently predicting its movement is extremely difficult, if not impossible. But that being said every edge a trader can gain in their interpretation and understanding of market psychology will enhance their market intuition, trading execution, and therefore, overall profitability.