Markets respond to the news, and the news responds to markets – it is a daily occurrence to find articles giving the market’s ‘response’ to some event as if it were a person capable of making judgements and decisions. Headline indices are used as barometers of success by both journalists and policymakers; the recent passion for data only further entrenching this habit. Knowing all this, it is odd to think that its also a well-known fact that markets habitually overreact, and respond to the news in irrational ways. Far from being a perfect final judgement on the prospects of a national economy, or even the business performance of a single public company, the market price shows fluctuations in the price of a security, driven by supply and demand.
Armed with this knowledge, traders can sometimes profit off opportunities where the market makes a sudden move, such as after a shock announcement or in response to economic data. Very often, the short sudden trends that these events create overreach, and are followed by a correction, which sometimes returns to the level below the trend and sometimes just erases part of the gains (or losses). In both cases, a responsive trader can act, though like any mean reversion / contrarian strategy, trading overreactions requires extra special care.
How do markets overreact?
Markets tend to overreact when they are surprised: for example if a company misses its earnings targets, or when a central bank announces an interest rate rise without warning. Traders will often refer to ‘expectations’ or even a certain event being ‘priced in’ – what they mean by this is that activity in the spot and futures markets indicates traders are expecting a particular result. If, for example, futures contracts are trading at a lower value than the spot contract for a currency, traders may expect negative economic news from that country. When these expectations are confirmed, markets still move, but typically to a lesser degree than when an announcement shocks the market.
The market can be ‘shocked’ in two ways – one, where the market expectation was in the correct direction but underestimated the scale of the move, and two, where the announcement contradicts the expected direction. Overreactions to the second type are normally much stronger, as market participants struggle to respond to new information. To profitably trade an overreaction, the news announcement needs to be enough to spook the markets, but not enough to fundamentally change the underlying trend. This way, the price will quickly trend back towards its previous level, partially or even entirely erasing the original price move.
Two examples will help illustrate the point: imagine you are a trader, working on a desk specialised on the AUD/USD, and you are waiting for non-farm payroll numbers from the US. You believe that the numbers will be strong, and so have reduced some of your long AUD positions in anticipation, perhaps even hedging with options in the case of a significant downwards move. In scenario one, the number is strong, but far stronger than expected, producing a sharp downward move in AUD/USD. Un-hedged market participants may see positions stopped out, and will often react suddenly by dumping their AUD exposure at an unfavourable price. Stop loss triggers and sudden sales drive the price lower, to a point at which long interest again outweighs short, and the price recovers.
In the second example, non-farm payroll numbers unexpectedly weaken. Traders, including those who had hedged against the expected US dollar strength, are taken by surprise, and a new trend in the AUD/USD is all but certain. As traders try and close hedges and move their positions, a sharp strengthening of AUD/USD is expected, and unlike in example one this trend will likely continue as it reflects a real change in market conditions.
How to trade overreactions
Both types of example can create overreactions, but traders looking to profit on them should limit themselves to the first category. Market announcements that change the directional view of the market tend to start real, protracted trends, even if they start with an overreaction and see a slight correction. The first group are much simpler since they seldom change the underlying dynamics of the market, and for responsive traders can be used as a quick entry and exit point for a contrarian trade.
When trading in this manner, you are entering a position that goes against the trend, so your stop loss needs to be much tighter, risk management is of greater importance, and you should commit a smaller portion of your portfolio than for a trend-following position. The reasons for this are simple – when trading against the trend, you are more likely to fail. Reversals strategies are notorious for being harder to execute, though the returns on successful trades can sometimes be higher. Another important thing to remember is not to keep the trade open for too long, since the sort of movements involved in an overreaction are necessarily brief.
To successfully trade an overreaction, you need to first identify one, decide whether it is likely to start a new trend, and if not, to enter a contrarian trade against the direction of the initial market reaction. It is normally sensible to set your take profit level a small distance above (or below, for a negative reaction) the pre-event price, as not all overreactions will be completely erased. The stop loss must be placed at a sensible level to ensure the trade is exited if a new trend forms.
Points to remember
Trading overreactions can work well if you maintain some basic principles. Like all trading strategies, trading overreactions relies on an understanding of the market principles behind the moves. In order to set your stop loss and take profit levels accurately, you need to have an idea of whether and to what extent the market is overreacting.
Like all contrarian strategies, trading against the trend requires a willingness to take risks, as the momentum of the price move is working against you. Trading overreactions also requires speed and snap judgements about the severity of often complex events; there is not always time to wait for oscillators or other indicators to confirm a weakening of the reaction. Critics who dislike mean reversion strategies are quick to jump on overreaction traders for this reason, claiming they are acting blindly based on instinct. But the measurable fact remains that sudden announcements do, very often, produce overreactions which then partially reverse.
How Rakuten can help
Overreactions are a good way of trading mean reversion strategies, especially if you are disciplined in how you identify these moves and use proper risk management practice when trading them. With that in mind, why not open a free demo account and start trading today without risking any of your capital?