5.1 INTRODUCTION

It is broadly accepted that financial news moves stock prices either through a direct impact on a company's expected future cash flow, the discount factor that one uses, or through more behavioral or sentiment-based mechanisms. Even though news-based trading has a long history of being part of investment decision making, only in recent years has it been possible to test “quantitatively” the impact of news events on individual stock prices or markets. Extensive academic and industry research has shown that news, particularly stories conveying sentiment, can add value in both high- and low-frequency trading and investment strategies—improving the prediction of price direction, volatility, and trading volume.

In a previous study, I made the case for applying a news sentiment index in predicting future returns of the Dow Jones Industrial Average, and showed that taking this approach significantly outperformed a price momentum strategy (Hafez, 2009a). Tetlock looks at a regression model and finds that 10-day reversals are reduced following company-specific news, which indicates that public news is a proxy for information that has not yet been incorporated into the stock price (Tetlock, 2009). Engelberg et al. find that short-sellers' trades are more than twice as profitable in the presence of recent news, which provides strong evidence in favor of the idea that news presents profitable trading opportunities for skilled information processors (Engelberg, Reed, and Ringgenberg, ...

Get The Handbook of News Analytics in Finance now with O’Reilly online learning.

O’Reilly members experience live online training, plus books, videos, and digital content from 200+ publishers.