Information Pays: Trading on News

Information affects stock prices. This undeniable fact is brought home every day as we watch financial markets react to news announcements about firms. When firms report better than anticipated earnings, stock prices go up, whereas firms that announce plans to cut or eliminate dividends see their stock prices go down. Given this reality, any investor who is able to gain access to information prior to it reaching the market can buy or sell ahead of the information, depending on whether it is good or bad news, and make money. There is a catch, though. Information that has not yet been made available to markets may be viewed as inside information, and trading on it can then be illegal.

For any portfolio manager who wants to trade on information legally, there are three alternatives. One is to use the rumor mills that always exist in financial markets, screening the rumors for credibility (based on both the news in the rumors and the source of the rumors) and then trading on credible rumors. Another is to wait until the information reaches the market and then to trade on the market reaction. Implicit in this approach is the assumption that markets react inappropriately to news items and that it is possible to take advantage of these mistakes. The third alternative is to use information that is publicly available to anticipate future news announcement. Thus, if you can read the tea leaves correctly and predict which firms are likely to surprise ...

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