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Consistent Income Trading Options - How News Affects the Markets

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In the first article we discussed how options offer high probability strategies so that non-professional retail traders, like Karen the Super Trader, can make consistent income. The second article covered why trading the SPX, as Karen does, is the optimum approach when trading high probability strategies. And in the third article we discussed the Probability Model, and how it is used to objectively locate your short strikes. In this article we will be discussing how News (or newsworthy events) affects the markets.

For many traders, entering a trade is typically based on chart patterns and indicators (MACD, stochastic slow, RSI, moving averages, support/resistance, etc.). However, chart patterns and indicators have no predictive value (numerous independent studies have made this determination); their value lies only as an inducement to enter a trade; and the probability of profit (POP) on directional trades is typically 50% (or lower).

So what distinguishes successful traders from the vast majority? There are a number of criteria: money management; employing strategies that work; understanding the risk associated with each trade; and, timing your entry based on current events (scheduled or otherwise) that affect the markets.

Markets (and especially option prices) are based on expectations of market participants. Implied volatility (IV) is a direct measure of market expectations, and the VIX is the de facto IV standard for the S&P500. In fact, many traders look to the VIX to determine if the markets are complacent or nervous (the VIX is often referred to as the 'fear gauge').

News or events can be broken into two categories: scheduled events; and unexpected events. Scheduled events are classified as follows:

Overall economy: this includes the Quarterly GDP, International Trade, and FOMC (minutes, meeting, forecast). The FOMC is one event that could have long-term implications, when there are policy changes. The effects of GDP and International Trade typically are short-lived.

Consumer: this includes the Consumer Price Index (CPI) and Personal Income and Outlays. These are nice to know metrics, but their market impact is minimal.

Labor: this includes the Weekly Jobless Claims, Jobs Reports, and Unemployment Rate. The Fed watches both the Jobs Report and Unemployment Rate to determine the health of the economy. The Weekly Jobless Claims report, while important, simply provides a 'heads-up' and its market impact is short-lived.

Manufacturing: this includes the Durable Goods Orders, Industrial Production, ISM Manufacturing Index, Philadelphia Fed Survey, and Producer Price Index (PPI). All of these reports generally have little impact on the markets; that is, whatever impact might occur will be short-lived.

Unexpected events can occur at any time, and their impact on the markets can be substantial and long-lasting. Some events, like the 9/11 attack, cannot be anticipated; however, there are other events which the markets do anticipate. For example, when news from China or the EU (European Union) is unexpected, the markets will react violently, and usually last the day (or longer). This occurred on June 1, 2012 (the SPX dropped nearly 2 std deviations that day) when China's manufacturing report indicated a slowdown in its economy; news which increased market concerns in front of the Jobs Report. Many times the VIX (as it rises over the prior day or two) will indicate the market's growing concern and act as a 'tell'.

When news or an event impacts the markets, it does so in two ways: magnitude and duration. The greater the difference between expectations and the event (for example, a very bad Jobs Report), the greater the magnitude (expect the markets to drop significantly).

The event itself will generally determine the duration of the impact. For example, most scheduled economic news (like the Jobs Report) have limited duration (typically a day or two). However, scheduled releases from the FOMC, which deals with policy changes, tend to have much longer duration (generally weeks to months). And unexpected events, like military actions, Congressional actions, unrest in the Middle East, all have longer durations depending on the complexity and severity of the situation.

In conclusion, understanding the impact of news and events will help time both your entry and exits in a trade. If an FOMC report is scheduled, it is usually prudent to wait till the report is released and the markets have settled for a direction (I usually wait till the Close). On the other hand, if a bad jobs report causes the markets to drop precipitously and is putting pressure on your position, you might want to consider holding the position with the expectation that the markets will not follow through the next day.

If you would like to learn more about options, and how to generate consistent weekly income trading options, go to Options Annex.

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