Just turn on the TV or walk up to a magazine rack, and it becomes clear that the business of reporting financial and business news has changed dramatically over the last decade. We are bombarded by CNBC, the Nightly Business Report, Bloomberg, and CNN Financial, minute by minute, about every late-breaking piece of financial and economic news.

It's no surprise, then, that all of this media influence and attention can move the markets. The amazing part of this whole process, however, is how often what should happen, doesn't happen, and what shouldn't happen, does happen. Often, when the financial media dramatically report a piece of news that should send a stock or index soaring, the exact opposite effect occurs, and the stock or index gaps up, only to sell off sharply on news that you would think would have had the opposite effect. This process allows an astute trader to trade these "news reversals," by taking advantage of the "herd mentality" that the financial media continually stirs up.

This trading method requires a major news event to trigger a buy or sell signal. By trading news reversals, you can learn to take advantage of the fact that the majority of people are rational, and that they tend to react logically in the same way to the same outside stimuli. Because human beings are basically rational, the collective result of all of their actions can tend to cause an over-reaction in the market.

It's not that the market itself is irrational, but rather it is just reflecting the sum total of a massive group of people all thinking the same way, at the same time. This effect is only compounded by a financial news media that is more than happy to rev-up the crowd's emotions.

For example, if a stock market is nervous about inflationary pressures, and a piece of key economic data is released showing a big spike in unemployment, the equity market will take it as a very bullish signal and will likely gap higher. The media will fuel the bullish sentiment, analysts and experts will make positive statements, and traders and investors may launch into a buying panic. This obviously will cause the market to gap higher at the open, creating a short-term overbought condition.

Instead of moving higher, prices begin moving lower, and selling leads to more selling. Speculators who thought prices could only go higher begin to panic, and suddenly, what should have been a bullish day for stocks turns into a large selloff, as prices head lower.

In order to implement a proper news-reversal trading strategy, I have included some rules that TradingMarkets CEO and founder Larry Connors wrote about in Investment Secrets of a Hedge Fund Manager (M. Gordon Publishing).

The Rules

Rule #1: Wait for an extremely bullish or bearish event to occur after the market has closed. Equity traders can look at analyst actions, earnings reports, or takeover rumors. Futures traders can look for crop reports, weather reports, economic reports, or livestock reports.

Rule #2: Watch for the market to gap open above or below the previous day's high or low for a signal to occur.

Rule #3: On openings that gap higher, place a sell stop one tick below the previous day's high. On openings that gap lower, place a buy stop one tick below the previous day's low.

Note: Equities cannot be purchased via buy stops. They must be done manually.

Rule #4: After you are filled, stops should be placed at the morning's opening price. As prices move in your favor, stops should be adjusted to lock in profits.

One example of how the news-reversal strategy can work is Oracle (ORCL | Quote | Chart | News | PowerRating). After the bell on June 20, 2000, it announced better-than-expected earnings. Despite the fact that Oracle beat analyst expectations of 25 cents a share by 6 cents, worries about future revenue growth and a downgrade from a major wire house sent the stock sharply lower in after-hours trading.

As you can see, Oracle gapped lower at the open on June 21, but the reaction to the downside turned out to be a classic over-reaction that was fueled overnight and pre-market by a overly zealous media. By the close on the 21st, Oracle was in positive territory. Your buy would have been at 84 1/2 and would have been good for a couple of points.

In talking to Larry Connors about news-reversal strategy, he said he has certainly found that it works even better on futures than on stocks, due to the fact that futures have less intraday noise and trade much cleaner than stocks.

A good example of a futures news-reversal setup took place in July Coffee (KCN0 | Quote | Chart | News | PowerRating) futures on May 31, 2000 as is indicated on the chart below. Coffee gapped open on news that exporters were reducing production by 20%.

Coffee gapped open to 101.25. The sell stop would have been placed at the previous day's high of 100.90 and would have executed in early trading on the 31st. Prices then collapsed down to 93.00, leaving traders with a winning trade of $3000 per contract trade for the day. (The red line above indicates the previous day's high, and the green line shows where the entry trade would have occurred on the 31st).

Points To Remember

The main thing to remember about trading news reversals is that it can be a psychologically difficult strategy. When the financial media and all the "experts" reinforce the logical reaction to a news event, it's tough to trade against that reaction. You really can't use logic to trade this strategy. For example, it is hard to put in a buy stop in bonds when the so-called experts are saying bonds are going to go down.

The key to trading news reversals is to remember that you must toss out all of your preconceived notions in order to truly listen to the market when it is acting like a contrarian. After all, the market seldom seems to do what it is logically supposed to do, so developing the ability to trade by using this reverse logic can give traders an edge, when "the herd" is thinking logically.

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