An emerging area of study is in the area of "newsflow" based trading. There is a push to apply newsflow based trading to algorithmic trading. There are even plans by Reuters to make automated news specifically for robots. The question being: can the news offer a tradeable advantage?
Quantitative trading groups are eyeing the possibilities and software companies are developing products for the trading community.
An academic paper that was highlighted by CXO Advisory reports 21.1% annual returns before transaction costs (but none after transaction costs) based on analyzing the negative sentiment in financial news coverage utilizing a "standardized level of negativity based on word counts and the Harvard psychosocial dictionary. " This result that stocks are tradeable on news is consistent with another study that stocks with news exhibit significant momentum. The implication is that it takes the market a significant amount of time to react or overreact to news. In the author's words:
My results confirm two old strains of thought among investment practitioners, which have gained an academic following. First, investors are slow to respond to valid information, causing drift. Second, investors overreact to price shocks, causing excess trading volume and volatility and leading to reversal. The results are also consistent with a richer set of theories (detailed below) that try to explain short-run underreaction and long-run overreaction in terms of investor behavior.
The author found less drift with "good news" and more drift with "bad news," and the drift effect is higher for low priced and small market cap stocks. The author speculates that arbitrageurs may not be able to eliminate the pattern because shorting is expensive.
The long-range plan for CASTrader definately includes newsflow trading. An academic paper on ranking news articles is a potential starting point for developing trade the news algorithms. Automatic document classification using Bayes theorem seems a relatively easy way to classify documents, but would require training from an "expert."
Update: The Park Paradigm discusses such sites as Monitor110 specifically targeted at getting paying subscribers (institutional investors) news scraped from company employee blogs and other sources before it matters (e.g. makes it into the news - see graphic at left). Update: Information Arbitrage is the excellent blog of the President of Monitor110.
Update (via Kirk Report: Data mining will get a whole lot easier when the SEC adopts a new format for financial information called XBRL. Information Arbitrage has much more.
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