News Reading Algos in the Metaverse

By:

Chief Strategist at Interactive Brokers

They say that cemeteries are filled with indispensable people.  The adage, of uncertain origin, reminds us that even the most valuable people eventually must be replaced.  Yesterday afternoon we learned that Sheryl Sandberg, COO of Meta Platforms (FB) would be stepping down from her management role (though not her board seat). 

Many would have considered Ms. Sandberg to be the most indispensable person at FB after only Mark Zuckerberg, the company’s founder.  Besides being formidably intelligent, she is widely regarded as being one of the few people who can say “no” to Zuckerberg.  Normally the loss of the #2 executive at a major company would be considered a negative – particularly when that #2 is often the face of the company.  FB’s initial reaction was certainly negative, but only mildly.  After an initial sharp drop – it is typical for stocks to overshoot on major news stories — FB closed about 2.5% below where it was before the news broke. 

FB 2-Day Chart, 1 Minute Bars, June 1-2, 2022

FB 2-Day Chart, 1 Minute Bars, June 1-2, 2022

Source: Interactive Brokers

Since then, FB has recovered all its post-Sandberg losses.  Investors have seemingly decided either that the company remains in good hands or that Ms. Sandberg was not all that valuable after all. 

I’ll leave it for others to analyze the post-Sandberg value of FB.  That’s not my strong suit (especially because I am surprised that the stock price is blithely ignoring the news).  Explaining why stocks routinely overshoot – up and down – on market moving news is much more in my wheelhouse.

There are firms that use language driven algorithms that automatically scan headlines for market moving phrases.  It would be logical for them to have them programmed to sell on a story that contained the combination of “Sandberg”, “FB”, “resigns”, or similar.  It was considered quite an achievement when these firms hit the scene a few years ago.  They combined of machine and natural language processing along with good old market sense to get a real advantage when important news was disseminated. 

We learned about these firms the hard way, by losing lots of money while marking markets.  Some of these traders realized that options were an even better way to profit from news items than stocks.  We would find ourselves getting lifted on scores of calls or puts – depending upon the direction of the news – before we could react.  Our own algorithms would attempt to hedge, but by that point most of the damage had been done.  We had to do something.

Rather than attempt to beat them at their own game, we realized that we could play adequate defense.  We too could recognize when a story about a given stock was hitting the wires – the news services tag their stories with the symbol or similar metadata.  The crude but effective solution was to immediately widen our markets to the maximum allowable limit, usually $5 per contract, and shrink our sizes to the minimum, usually 10 contracts.  It meant that even if we were caught offside by the news reading algos, the damage would be minimal.  We would then decide whether to resume normal quoting once we had a chance to read and digest the news.

The flip side to that of course was that market quality stunk for that period of time.  We were not the only market makers to adopt an approach of that type.  But what was our choice?  We could either continue to quote aggressively and lose large sums of money periodically or step aside to the best of our ability.  If we didn’t make those periodic adjustments, market liquidity would have been much worse for much longer periods of time.

Traders should understand that there is always someone better and faster at reading the news than you, and that liquidity shrinks dramatically in the immediate aftermath of a key news item.  That is why prices tend to overshoot and bounce back somewhat in the wake of a news story.  One can try to take the other side of the initial move – it worked for someone yesterday – but that of course is quite risky and requires remarkable agility.  It is much more prudent to let the market settle out and make your trading decisions with a clear head. 

You’ve heard this spiel from me before – don’t chase and respect market liquidity.  But it was an expensive lesson to learn.

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