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Over the past few days, I’ve written a bit about trading macro events and reports, and I also did a podcast episode on the subject. I shared some ideas about the kinds of events we are talking about (and today’s looming FOMA at 14:00 EDT is a good example), but I think the most important things I said were the warnings about not trying to predict the outcome of events. That’s a highly specialized game and you will lose if you don’t really know what you’re doing.

Chess_piece_-_White_pawnFor most traders, the valuable lessons come from thinking about what you are or are not going to do around these reports. There are a several possibilities, and, as always, it is important to understand the tradeoffs. Every choice you make in trading is like moving a pawn in chess: you strengthen something at the cost of weakening something else, these seemingly tiny moves can make all the difference between winning and losing, and, in most cases, you can’t undo what you’ve already done.

Assume that you are holding a significant position with a clearly-defined stop and there is a scheduled event in the near future. We can accept that we don’t know what will happen when that event hits the market, but there’s a good chance that the position will become much more volatile than it has been–in other words, think of these events as a random shock–and potentially a very volatile random shock–to the market. Consider how that might impact your positions and risk.

Here are some things you can think about doing:

Tighten stops on open positions: This seems like a no-brainer: we are concerned about the market being more volatile, so just move those stops closer to the market price to reduce risk. This can make sense, but there are a few problems. First, in many markets, we might be concerned about slippage. If you’re ever going to be slipped 5 points in a market that usually has a 0.02 spread, it’s probably going to be following a report or an event! Also, we know (with a high degree of probability) that the market is going to be more volatile, so maybe we’re doing the wrong thing by tightening the stop?

Widen stops on open positions: This also could be a reasonable option, but we are actually increasing risk here. (Maybe that’s ok, but it has to be understood.) We also don’t know how volatile the market is going to be, so maybe our widened stop is just a big, fat target with additional risk to our trading book. Also,there’s still the chance of slippage–widening the stop and then getting massively slipped on the exit is literally adding insult to injury.

Widen stops on open positions and reduce position size: This one might make sense, but any time we take a partial exit, we essentially “de-leverage” our P&L either on the profit or loss side. If we take partial profits, this basically anchors our P&L line in the green, and gives us a higher probability of booking a profit on the overall trade, but it works against us to take partial losses. However, widening the stop and reducing the position size can have the overall effect of not increasing risk as market volatility increases. It seems like a perfect solution, but what’s the tradeoff? (Seriously, if the answer doesn’t come to mind immediately, spend a few moments answering that question.)

Every choice strengthens something and weakens something else. In this case, you’re reducing the risk, but you’re also reducing your potential profit. Don’t think about it on this one trade, but across hundreds of trades, and try to consider the interaction between outcomes and the probability of those outcomes. This is not a bad choice, but it’s no free lunch!

Do nothing at all: We may choose to just batten down the hatches and ride out the storm. In the end, the outcome might be the same (financially) as if we didn’t know the report was coming, but psychologically the impact is very different–and that does matter. Doing nothing is a viable alternative, especially for some kinds of traders, but you still need to know the report is coming.

A few parting thoughts: there is evidence that information leaks before events, and that’s worth thinking about. Though the evidence is a far cry from suggesting easy trading plans (anyone using this type of study to justify or explain the predictive power of traditional technical patterns is probably suffering from some degree of mathematical illiteracy), it does suggest there might be something there. Perhaps highly tuned quantitative tools, or finely honed intuition, could separate the signal from the noise in these cases. Worth considering, but you still gotta manage your risk. Above all, you always have to manage the risk.

(If you found this interesting, check out the podcast episode on the same topic.)