Good News Bad Action

The trading concept of good news/bad action is straightforward in nature, but it requires some counterintuitive thinking. Let me first share with you an experience I've had on numerous occasions as a guest lecturer to aspiring freshman at the Wharton School of Business at the University of Pennsylvania where I received my MBA. These future leaders of America possess both high S.A.T. scores and usually high opinions of themselves.

In short, a lot of them think that, at 18 years old, they know everything. Typically, I start my lecture with a hypothetical trading story. I tell them to imagine that they're watching the "CBS Evening News with Dan Rather," and he's standing in some Midwest cornfield up to his knees in water, reporting that the Mississippi River has overflowed and the corn crop is decimated. Dan Rather then goes on to interview a couple of farmers who are suffering tremendous financial losses.

Furthermore, I tell them that the next day at the Chicago Board of Trade, where corn futures are traded, corn is expected to open limit up—meaning 10 cents a bushel higher. However, when trading begins, instead of opening limit up, the market is only 6 cents higher, and within an hour it's trading unchanged on the day. The question that I ask the students is, what would they do? How would they capitalize on the situation? Would they buy or sell corn futures?

Almost to a person, every one of them says that they would be a buyer. These geniuses figure that the market is affording them an incredible buying opportunity and has yet to digest the impact of the flood on the supply of corn. They think only in terms of supply and demand. Wrong answer! Obviously, this hypothetical story is a perfect example of good news/bad action. The good news—at least in terms of market pricing—is that a flood has occurred that will reduce the size of this particular harvest. The bad action is evident by prices not meeting the opening call and quickly trading back to the prior day's level. In this instance, you would want to be a seller. For whatever reason, the market has run out of steam, and the buyers have run out of bullets.

Typically, those buyers who got long the market because of this supposed good news are the first ones to get stopped out of their long positions at the first sign of weakness. Usually the market will continue to trade lower for a couple of days, and these traders have no idea where they went wrong. What they've missed is the possibility that the crop damage was already priced into the market, meaning prices had already advanced in anticipation that the flood would take out a certain amount of acreage. Or, maybe the corn crops that were damaged were not even deliverable against the CBOT contract. Who knows? Whatever the reason, this is a clear example of a good news/bad action situation.

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