Why Hedge Funds Trade on Headlines—And Why You Shouldn’t

Over the past four decades, there’s been a significant shift in how trades are executed on Wall Street. In the late 1970s, algorithmic trading was first introduced to the New York Stock Exchange. Since then, more and more institutional investors, hedge funds, and brokerage firms have started using algorithms for their day-to-day trading actions. Algorithmic trading now accounts for nearly three-quarters of all the equity trades executed in the U.S.

Algorithmic trading has some merits, primarily that institutions, hedge funds, and brokerages utilize algorithms to help minimize trading costs for large orders. Algorithms also allow firms to execute trades at a much faster pace than an individual investor, enabling the firm to quickly lock in a better buy or sell price for its clients.

The biggest problem with algorithmic trading is that it removes people from the process.

Essentially, a computer analyzes the latest headlines, economic data, earnings reports, and global developments and assesses how it “thinks” investors will react to the information. Trades are then executed based on assumed behavioral patterns (as expressed in the algorithms); how the computer believes investors will respond.

You could also call this “trading the news.” Several hedge funds have created computer models that analyze the headlines and trade based simply on the news. There’s even a London-based hedge fund that analyzes tweets to determine investor and market sentiment, then makes trades for its clients based on this analysis.[1] A Japan-based hedge fund makes investments in the Nikkei 225 futures after analyzing Japanese blog posts.[2]

It’s an interesting strategy but is it a viable investment strategy for individuals?

Back in December, trading volume was light, and major headlines were few and far between. As a result, volatility dipped, and the major indices traded relatively flat to slightly higher between Christmas and New Year’s Day. The S&P 500 rose 0.8% in the five trading days between the holidays; not atypical, by the way, as most investors take that week off.

But as individual and institutional investors returned from the holidays, the volume of financial headlines surged—news about the latest Federal Reserve meeting, the economy, and spreading Omicron cases spiked. Market volatility surged, and stocks sold off hard.

Headlines discussing the 10-year Treasury’s jump to more than 1.7% drove down technology and dividend stocks. The algorithms were trading the news.

As individual, non-electronic investors, we should also always have an eye on the news. We, too, should assess current conditions and how they may impact the stocks we own. But constantly reacting to the news can be costly and could derail your long-term financial goals.

Often the most challenging part of being an investor is being patient and sticking to your financial strategy, especially when it feels like everyone else is making investment decisions based on the news. We need to remember is that investing is a marathon, not a sprint—you should always make financial decisions with an eye on the long term.

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[1] https://www.next-finance.net/Social-network-a-new-trading-tool

[2] https://www.next-finance.net/News-trading-Hedge-fund-analyzing