There are a number of different strategies that active traders use to profit in the financial markets, ranging from various forms of technical analysis to trading based on Level II quotes and order books. While many of these strategies rely on technical factors that predict price changes, traders may also want to consider the impact of fundamental events that can have a dramatic impact on prices over the near-term instead of just the long-term.
In this article, we’ll take a look at event-driven trading strategies and how they can be used by active traders to improve their trading performance.
Be sure to also see our Guide to Position Trading.
What Is Event-Driven Trading?
An event-driven strategy involves placing trades based on market-moving events, ranging from earnings announcements to natural disasters. Since volatility tends to increase during these times, active traders have an opportunity to generate a higher profit than they would otherwise be able to in range-bound markets. This volatility can be measured in a number of different ways, ranging from beta coefficients to daily volume versus average daily volume.
After identifying potentially volatile situations, traders must determine the direction of any future price movement and the best strategy to capitalize on that movement. These factors are largely determined by looking at various technical indicators, chart patterns, or other forms of technical analysis. For instance, a breakout due to favorable earnings could coincide with an ascending triangle pattern, which often predicts a specific price target.
Common Market-Moving Events
Stock prices reflect a constant stream of new information and changing investor expectations of what the future holds. While a lot of this information is relatively benign in nature, such as weekly job reports or financial commentary, there are many events that are capable of dramatically moving the market for a given stock or index. Recognizing these events is the first step in capitalizing on the resulting price volatility.
Some common micro-level events to watch include:
- Earnings Releases – Corporate earnings tend to move markets when they come in above or below the market’s expectations, which means that it’s important for active traders to understand the expected figures beforehand.
- Mergers & Acquisitions – M&A tends to produce dramatic increases or decreases in share prices depending on the terms of the deal, while creating an opportunity for arbitrage strategies between the buyer and seller.
- Spin-Offs – Spin-offs tend to see an initial decline in share price as institutional investors who received shares sell off their stake to comply with regulatory requirements or other rules, thereby creating opportunities for traders.
See our Guide to Merger Arbitrage Trading.
Macro-level events to watch include:
- Natural Disasters – Natural disasters can spark dramatic movements in the equity markets, especially in certain sectors that are exposed. For instance, a hurricane in the Gulf of Mexico could hurt oil companies with rigs in the region.
- Politics – Political issues can have a dramatic impact on some equities, especially in parts of the world where policies can change dramatically. A new regime in an emerging market, for instance, can have a big impact on the country’s ETFs.
- Monetary Policy – Central bank monetary policy changes can have a big impact on broad equity indexes, since interest rates directly influence portfolio allocations, which means that these events are important for traders to monitor closely.
See also A Brief History of Penny Stock Chaos.
There are many different ways to capitalize on event-driven volatility in individual securities or entire indexes. While some traders may decide to simply purchase a stock after a market-moving event occurs, others may choose to use options or other derivatives to leverage their exposure to the market and capitalize on the opportunity in a different way. The best strategies depend largely on a trader’s knowledge and risk tolerance.
Let’s take a look at an example of a possible event-driven strategy:
In Figure 1 above, Egalet Corporation (EGLT) experiences a breakout due to favorable top-line results in one of its clinical trials. A trader implementing an event-driven strategy may have taken notice of the positive clinical trial results and purchased the stock after it broke above the descending trend line resistance. After making the purchase and holding the stock into the second day, the trader might lock in profits by setting a stop-loss just below support levels at around $7.50 and set up a take-profit price target at the psychologically important $10.00 level that also happens to be a historic resistance level.
Now, let’s look at an example of the opposite scenario where a trader may enter into a short position to take advantage of an adverse event:
In Figure 2 above, Uroplasty Inc. (UPI) breaks down below the prior low and psychologically-important $2.00 support level after being downgraded by Roth Capital analysts. An event-driven trader may decide to enter into a short position following the breakdown below $2.00 and set up a price target at long-term prior lows of around $0.30 or perhaps at the psychologically-important $1.00 price level where they would then buy back the shares and profit from the trade.
Learn about the 7 Psychological Traps Every Trader Must Face.
Risks & Limitations
Event-driven trading represents a great way to profit from increasing volatility, but the strategy isn’t without any risks. Given the increased volatility, there’s a risk that the security could recover just as quickly as it fell or vice versa. These dynamics are particularly prone to occur in events that may be reversed, such as a merger that falls through or an analyst note that turns out to be based on faulty information following revelations in a new 10-Q filing.
Some important risks and limitations to consider include:
- Volatility – Volatility is a double-edged sword in that any potential increase in upside is accompanied by a potential increase in downside risk, which makes it important for a trader to fully understand the event and set up tight risk controls.
- Whipsaw – Some trading events may cause whipsaw price action that can trigger stop-loss points before a trading thesis can materialize, which means that traders should keep loose stop-loss points to permit some volatility to occur.
- Knowledge – Many market moving events are quite involved, which makes it hard to fully interpret and digest the information. For instance, clinical trial results may be hard to instantly decipher as good or bad before the price moves substantially.
The Bottom Line
Event-driven trading strategies provide a great way to capitalize on increasing price volatility, but there are many risks and limitations to consider. When developing and executing these strategies, it’s important for traders to set up tight risk controls while providing enough room for the volatile situation to play out in the market. In the end, event-driven trading strategies provide a valuable arrow in the quiver of any active trader.