Event Trader Tactics - The Basics for the Small Trader

Events moves the stock prices. Period. That's the main principle for the event trader.

Event traders are event hunters.  They look for them, estimates the probably consequences on certain stocks, including the reaction of the mass, do some maths, and act accordingly.  As everybody in this game, sometimes they are right, and sometimes they fail. 

There is a lot of logic in the event trader reasoning, and properly applied, they resemble very much the fundamental investor way. The problem is that the "human factor" in the market (greed and fear) introduces a lot of noise in the process, and the volatility associated to market events is very high.  This implies some extra risk, bigger than trading in non-event days. Here we will show some events of interest and some ideas on how to profit from them.

	Earnings announcements This is likely the most well known event in the market.  We know in advance when the earnings conference will happen, but cannot predict what will be announced.  The market analysts research the variables that affects the industry of a particular stock and try to predict what numbers will be the issued, particularly the Earnings Per Share (EPS).  The analyst consensus is obtained by averaging the EPS of all the analysts following the stock.  The basic logic is that if the company makes the number, no problem, the stock is not affected. If the company fails behind, the stock trembles. If it surpasses big the consensus, the stock soars.  Big deviations in the EPS (for good or bad) moves the stock, as it implies normally a change in the underlying assumptions. There are several possible tactics. A very well known is to plan straddles or strangles near with expiration very near to the earnings announcement date. If the stock soars or crashes, you make money anyway.  This makes sense in volatile industries and when the uncertainty is high. The drawback is that normally the premiums paid for such options tend to be abnormally high. Another approach is try to guess if the company will make it or fail, and use options as the vehicle investment. The drawbacks are that a mistake may make the option to become worthless overnight, and, again, the premiums paid will require a large movement in the stock price to make the operation profitable. Because of that, a third approach is to wait until the news are released, see the results, and try to catch the trend or counter trend that the event originates.
	Inclusion in S&P 500 index S&P 500 has to have 500 members.  When S&P drops a ticker, it should replace it immediately by another, following certain guidelines.  The stock added to the index normally (but not always) jumps 4-5% the day of announcement, and climbs up around 2.5% until the stock is effectively added. The next day, almost always, the price has a moderated correction.  These movements, however, are very erratic and volatile. Stop offs are triggered easily. One tactic to apply is to have always a list of stocks candidates to be added to the list, pretty well analyzed in terms of healthy and exposition.  Once a delist is rumored, put your bet in 4-5 candidates with options cheap (low IV), so if there is an announcement, one of them should soar immediately.  The others can be sold timely at the better price possible. Another tactic is to buy calls or go long immediately after the announcement, and get out the day of the effective inclusion.  A third tactic, is to buy puts the day of the inclusion to take advantage of the correction the next days. Please note that the options premium will be expensive due to the expected volatility.
	Options expiration Options expire the third Friday of the month, they become worthless.  There is a number called Max Pain ®, that is the stock price at which it produces the maximum loses in premiums for both calls and puts, based in the open interest registered for each strike.  The theory is that the day of expiration, market forces drives the stock price to converge toward that price. The tactic to apply here is to sell cones or strangles, as there should be some volatility, but the price will end up in a known price. Again, this is the theory.  Reality is different. Sometimes the Max Pain ® theory works like clockwork, and in some other, the stock pays no attention to the number, and moves strongly in one direction.  If you play this game, be sure to have strict stop offs.
	Mergers & Acquisitions These events happen all time, but are more frequent in extreme markets, both bullish and bearish. For a discussion on the mechanics, please check Investopedia.  Normally, the acquiring company announces that the purchase will happen with a stock price higher than the current market quote.  This creates an arbitrage opportunity: after the announcement, a purchase can be done and expect to have a profit when the purchase operation concludes. The risk here is that the operation does not take place, and the price stock get affected by that.  Another problem is that these kind of operations can take more time than anticipated (average is four months), affecting the ROI of the transaction.  Despite to these drawbacks, it is the type of operation preferred by top investors, such as Mr. Buffett. An important note: these investments should be done based on formal announcements, not rumors. The risk is much higher with rumors, and for a small trader with a tiny capital, it can be disastrous.
	Special dividends There are times when companies decide to pay a special one-time dividend. These are rare and can occur for a several distinct reasons, for example, a major litigation win, the sale of a business or liquidation of a investment. As rates of taxation on dividends are low, this is an interesting option. Sometimes, this special one-time dividends are classified as a “return of capital”, and in this cases they are tax-free. This creates arbitrage opportunities. More importantly, most of the companies that declares this special one-time dividend. According to a recent study, investors usually climbs the price up to unusual levels before the dividend ex-date, and then of course, once the dividend is paid, the stock prices decreases in the same amount as the dividend.  But, in most cases, after this point the stock usually initiates a steady climbing and recovers the pre-dividend prices. The proposed strategy would be to buy the stock before the dividend, get the money back partially as a dividend, and then, wait for the stock recovery.  If the stock has options, you may even sell puts periodically to enhance the ROI of the operation.
	CEO removal It is usual that when a company performs poor, the CEO gets removed. Sometimes, the board even appoints a manager coming outside the industry, so he can bring a new approach to the company's strategy and a renewed leadership.  Curiously, although initially the CEO removal adds a temporary volatility to the stock, and even a decline, the typical effect in the medium term is that the company starts a steady climbing, with better results for those CEOs that came outside the industry. A recommended buy signal is having the price cut by half from the 52-week high, and almost simultaneously, a CEO removal.  Be sure that the company has a low P/E ratio, this is a value-based investment. This conditions could sign the start of a bullish trend for the company.
	FED meetings FED meetings results are the best sign to predict the whole market future tendency.  They meet 8 times a year, and the basic agenda is to decide whether they change the federal funds and the discount rates.  The analysts community issue a consensus on what the FED would do and the market acts accordingly.  The choices are: decrease, keep and increase rates. If there is a surprise (this is infrequent) the market moves strongly, up or down.  For example, if the analysts estimates that the FED will keep the rates, and they are lowered a quarter point, this likely will be translated in a temporary strong bullish tendency in the market. More important for the investment community is the economics outline posted on the communicate. It is usually seen as an indicator of the future direction to be followed by the FED. The strategy recommended here is to try to detect the odds of having a surprise and bet on that possibility if there are cheap (low IV) options available for market indexes.
	Disaster events Events like Katrina Hurricane disaster can be used to speculate on the market.  The natural disasters creates conditions where construction industry flourish, as they got an unusual demand. Learn which are the largest companies operating in or near the affected zone, analyze their fundamentals, and speculate on an temporary aggressive growth in the short term. Also, oil related stocks can be positively affected, if there were oil related engines in the zone affected. The event will likely reduce the oil global supply, making the oil prices go up. This will benefit the oil industry in general, except for those companies which logistics operations may be severely affected by the disaster.