Stock Market Outlook: February 2024 - NerdWallet (2024)

Spring is around the corner, and for investors, so are many important economic data releases, earnings reports and news events. Some of them could affect the chance of a Federal Reserve interest rate cut next month.

But is trading on those news events a good idea? In this issue, we’re looking at what science says about news-based trading strategies.

Plus, are options only good for day trading? Not necessarily: read on to learn about an option trade that can fit into buy-and-hold investing strategies.

In this issue

Is trading on news events a good idea?

On Nov. 19, 2023, the Houthi rebel group in Yemen began attacking merchant ships in the Red Sea in an effort to impose a de facto naval blockade against Israel in retaliation for its role in the Israel-Hamas war.

In the following weeks, maritime traffic through the Bab el-Mandeb strait near Yemen cratered, as ships rerouted to avoid the danger. In 2022, the latest year for which full-year data is available, about 12% of the world’s hydrocarbons passed through this part of the Red Sea. In January, several tanker companies halted Red Sea shipping altogether in response to U.S. and U.K. airstrikes against the Houthis.

Given this supply disruption, you might think that a chart of Brent crude, the world’s most widely followed oil price benchmark, would show a dramatic jump in oil prices.

But you’d be wrong. Brent crude has only inched above its pre-Houthi-attacks price level one time since the attacks began, in late November. Otherwise, it has traded downward.

Source: Finviz. Data is current as of Jan. 24, 2024, and is intended for informational purposes only.

Why isn’t the Middle East news moving oil markets?

Some investment analysts predicted months ago that the attacks were unlikely to move markets. Goldman Sachs (GS) wrote in a note dated Dec. 18 that the violence in the Red Sea probably wouldn’t have much of an effect on global oil prices because it was only rerouting shipments and not hurting production.

“We do estimate that a hypothetical prolonged redirection of all 7 million barrels per day of gross (Northbound and Southbound) oil flows would raise spot crude prices relative to long-dated prices by $3-4/per barrel,” the note said, according to reporting by Reuters.

For reference, Brent crude was trading at about $78 per barrel at the time, so Goldman Sachs was projecting an increase of only 4% to 5% in a worst-case scenario.

The underwhelming effect of the Houthi blockade on oil prices is an illustrative example of the challenges of trading on news events.

What the research says about news-based trading

Studies suggest that news-based trading strategies can be a viable way to beat the market — as long as you have a supercomputer, a lightning-fast internet connection and a team of data scientists working for you.

Since 2020, two papers on news-based trading strategies have been published on Cornell University’s arXiv repository, one by researchers at the University of Adelaide, and the other by researchers at Northwestern University.

Why news-based trading is tough for individual investors

Researchers are much less enthusiastic about news-based trading among retail traders. A 2022 study by economists at Stanford University and the Massachusetts Institute of Technology examined the options trading behavior of retail investors over the course of more than 32,000 earnings announcements between 2010 and 2021.

The implication is clear: News events get “priced in” to stocks, commodities and options in the blink of an eye. They can sometimes be useful signals for high-frequency algorithmic trading systems, but the human brain generally works too slowly to trade on them effectively.

Alternatives to trading the news

News may get priced in to the stock market faster than you can trade, but that doesn’t mean that it always gets priced in correctly. And when the market is wrong, individual investors have an opportunity to beat it using other strategies.

For example, value investing is a strategy based on buying undervalued stocks, companies that the market is pricing excessively low in terms of price-to-earnings (PE) ratio, based on bad news or a lack of momentum.

Other investors focus on dividend stocks, companies that provide their shareholders with income along with stock price growth.

Still other people are growth investors. They seek stocks whose earnings per share (EPS) or revenue are rising faster than the market average.

None of these strategies is always the “correct” one, though, and they all alternate through periods of outperforming or underperforming the market. In the last year, for example, exchange-traded funds (ETFs) of growth stocks have beaten the S&P 500 index by a wide margin.

Term of the month: Put selling

Generally speaking, the long-term investing strategies described above don’t have much to do with options trading.

Value investing, for instance, is about finding undervalued stocks and holding them until they’re not undervalued anymore, not buying call options ahead of a big earnings report.

But in truth, there are other ways to use options besides speculation. In fact, there’s an oft-overlooked option trade that can be paired with long-term investments. That’s the act of selling, or “writing,” put options.

What is put selling?

Put selling means entering into a contract with a put buyer in which the buyer pays you a small amount of money (a “premium”) in exchange for the right, but not the obligation, to sell an underlying stock to you at a specific “strike price,” on or before a specific “expiration date.” Each contract typically controls 100 shares of the underlying stock.

As the seller (or “writer,” in options-trading parlance), you are obligated to buy the underlying shares from the put buyer, if they exercise the option. You don’t have to do anything if they don’t exercise it.

The buyer is likely to exercise the option if it’s “in the money,” that is, if the market price of the underlying stock is lower than the strike price. In that case, they can sell the shares to you for more than they’re worth on the market.

This allows them to make an instant profit by buying the shares at the market price, and selling them to you at the higher strike price. You, on the other hand, get stuck buying shares whose resale price is lower than the amount you’re paying for them — but as we’ll discuss later, that isn’t always a bad thing.

If the option is “out of the money” — that is, if the market price of the underlying stock stays higher than the strike price until expiration — then the put is worthless for the buyer, and they will likely let it expire without exercising it. In that case, you as the seller get to keep the premium the buyer paid you without taking any further action.

Because of these incentives, put selling is implicitly a bet that the underlying stock will rise in price before the expiration date, while put buying is implicitly a bet that it will fall before the expiration date.

What are the risks?

The main risk of put selling is that you could be forced to spend a bunch of money buying a stock for more than its market price, although that isn’t necessarily an unwanted outcome for all traders.

The absolute worst-case scenario for a put sale is that you are forced to buy a stock whose market price goes to zero, in which case you’ll never be able to resell it at all, and you’ll have to accept the complete loss of the money you paid to buy it at the strike price.

Consider, for example, a fictional stock called ZYX Corp. whose shares are currently trading at $50. Suppose that you sell ZYX puts with a strike price of $50 for a premium of $5, so one contract (controlling 100 shares) costs $500 for put buyers.

The graph below shows your profit or loss, depending on ZYX’s market price on the expiration date of the option. Your maximum profit is $500 (if the option expires worthless), while your maximum loss is $4,500 (if it is exercised, and you are forced to buy 100 shares of the stock for $50 per share, minus the $5 premium you received per share, when it has a market price of $0).

Put selling profit and loss

To ensure that put sellers can fulfill their obligation to buy the underlying stock upon exercise, many brokers require investors to have a margin account with a certain level of buying power to sell puts.

If you sell a lot of put options, you may also want to keep an eye on market volatility levels, as measured by benchmarks like the VIX volatility index. Volatility is a factor in option pricing, and low volatility can push down the premiums that put sellers can collect.

How do investors use put selling?

Some investors sell puts to generate income from a stock that they think will rise in the future. This can be an especially effective strategy when most investors think the stock will fall in the near-future, and when market volatility is high — as negative sentiment and high volatility both increase the premiums that sellers can demand from put buyers.

But there’s another use of put selling that can complement buy-and-hold strategies like value investing: to buy stocks for less than you believe they’re truly worth or get paid for trying.

Let’s revisit our example: Suppose ZYX Corp. has a PE ratio that is 50% lower than its competitors. Based on this, you believe that ZYX is trading at a 50% discount — that its shares should be worth $100, rather than $50.

In that case, you might sell a put option with a strike price of $50 and a premium of $5, and be happy even if the buyer exercises the option and sells you the shares at the strike price.

In such a scenario, you’d be on the “losing” end of the option trade, and your ZYX shares might initially be worth less than you paid for them but you’d still be buying ZYX for less than you believe it’s worth in the long term.

If your theory is correct, and ZYX shares rise to $100 in the months or years ahead, you’d still be able to sell your shares for $10,000, with the satisfaction that you only bought them for $4,500.

If the put buyer doesn’t exercise your option, then you wouldn’t get the stock, but you’d still be happy to receive $500 for doing nothing. (That’s the “or get paid for trying” part.)

But if you understand the risks of put selling, and you’re interested in buy-and-hold investing strategies on undervalued stocks, put selling can sometimes serve as a way to buy stocks at a discount or make some cash while attempting to do so.

Dates that could move markets this month

Economic events

Source: CME Group. The FedWatch tool uses futures market data to estimate the probabilities of different Federal Reserve interest rate decisions. The chart above shows a 53% chance that the Federal Reserve will cut rates by 25 basis points at its March meeting. Data is current as of Jan. 31, 2024, and is for informational purposes only.

Earnings

January was a big month for tech earnings announcements, and February is as well:

It’s also a major earnings report month for oil stocks:

Many major biotech firms will also report earnings in February:

Neither the author nor editor owned positions in the aforementioned investments at the time of publication.