Doing This Will Just Drive You Crazy

Many short-term traders try to make money by guessing which way stocks will move on any given day. Yet by doing so, traders take on two separate but equally difficult challenges: figuring out what news items will have an impact on a given stock, and making a call on how the stock will react in response to that news.

You might think that guessing right on potentially crucial news items for a company would be far more difficult than figuring out which way the stock would move in response. But in the short run, the market can confound you by doing pretty much the exact opposite of what you would expect.

Being right but still losing
On Tuesday, an article in Barron's discussed how a trader had made a large bet on health-care stocks. To maximize potential profit, the trader had bought call options for millions of shares of the Health Care Select Sector SPDR (XLV), a sector exchange-traded fund that includes shares of about 50 different health-care companies, including Johnson & Johnson (NYSE:JNJ), Pfizer (NYSE:PFE), and Abbott Labs (NYSE:ABT). By buying a number of options with strike prices slightly above the current share price, the trader evidently hoped to cash in on a big move up in the ETF's shares.

As the article pointed out, the timing of the trade was clearly pegged to the special Senate election in Massachusetts, which had huge implications for the fate of health-care reform in Congress. The logical theory was that if Scott Brown, the Republican candidate, won the election, then health-care reform would stop in its tracks, and health-care stocks would soar in response. And indeed, the ETF's shares rose during the trading day on Tuesday, as speculation built about Brown's chances of success.

As it turned out, the trader got the call right: Brown won the election. But look how health-care stocks responded:

Source: Yahoo! Finance.

All told, rather than soaring on the election news, the health-care ETF lost about 0.9%. And although the options trader still reportedly had a profit on the initial options position, the calls the trader bought fell by almost 17% in a single day. How frustrating!

Selling the news
This sort of thing happens all the time throughout the financial markets. Investors try to anticipate what will happen next and invest accordingly. Yet even when they anticipate correctly, the way they chose to trade on that prediction turns out to be wrong; instead of giving you the payday of your dreams, your investment stays flat, or even worse, sells off, leaving you with a loss.

Unfortunately, there's no good way to get ahead of the crowd. Even if you buy early on rumors, you're still at the mercy of an irrational market -- and you can easily get bitten.

How to win? Don't play
As frustrating as it is sometimes, the lesson you should learn from this is that trying to guess short-term movements on stocks is practically impossible. Even if you believe that markets incorporate all known information into stock prices, it’s hard to figure out how quickly expectations about the future are incorporated into short-term price movements. That makes the markets look irrational even when they're not.

That doesn't mean you should ignore news items entirely. Over the long run, good news should have a dramatic impact on a company's business prospects, improving profitability and leading to better financial fundamentals. That in turn will generally push a stock's price higher over time.

So unless you see the stock market as a more convenient alternative to heading to your local casino, steer clear of making short-term bets on market moves. It will only frustrate you, and take your eyes off the ultimate goal of picking great investments that can make you truly rich over the long haul.

There's only one place to look for the best investments. Tim Hanson knows the one stock you must buy.