To some people, perceived risk and actual risk may seem like two sides of the same coin. However, in reality, they are very different, and they can significantly impact share prices. Day traders can use perceived risk in both bull markets and bear markets. An activity which you could describe as trading on sentiment?
We will now take a look at two examples.
Downbeat trading statement
If we assume that Company A is about to go into a closed period ahead of final results, some companies will release a trading statement. On this occasion, let's assume that the company highlights a challenging trading environment and suggests that annual profits could be anywhere between £100 million and £150 million (below expectations) against £250 million last year. How does the market react?
There will be surprise that the company is struggling in a buoyant market, and, in a downbeat market, many might be expecting even lower profits. Consequently, the shares will suddenly be valued on earnings of £100 million in a best-case scenario. However, negative headlines, immediate sellingpressure and short-selling could push the share price way below fair value, even if actual profits were as low as £100 million.
This is the actual maximum risk; the chance that profits will fall from £250 million last year to £100 million. Then, twomonths further down the line, the company announces annual profits of £125 million, the worst-case scenario is avoided, and the share price recovers. In all likelihood, the initial fall in the share price would have gone way beyond even the lowest case fair value. Traders would have realised this, looking for a bounce-back towards the lowest justifiable share price. Hence, they have traded the perceived risk against the actual risk; they have traded on sentiment.
Upbeat profits forecast
Let's assume that Company B issues a pre closed period trading statement suggesting that profit will be well up on last year’s £100 million. They will likely be between £150 million and £200 million, way beyond market expectations. The knee-jerk reaction would likely be a surge in the share price, smashing through all resistance levels and the emergence of a new upward trend.
In this scenario, it is not inconceivable that the share price valuation will go way above fair value on the £200 million maximum expectation. What can we expect next year, the year after and beyond if trading is that good? Investors suddenly show interest. Surprising on the upside can lead to as dramatic a share price movement as disappointing on the downside.
Stock shortages, traders jumping on the trend, and long-term holders reluctant to sell can prompt dramatic price movements. Fast forward, the company announces profits of £180 million, forecasts for next year are reined in, profit-takers emerge, and the share price pings back. Active traders could just as easily have bought in on the way up, sold at the top, then shorted the stock and bought back when the actual profits were announced – yet another example of trading on perceived risk, actual risk and taking advantage of market exuberance (sentiment).
Bull and bear markets
Companies announcing better-than-expected profit expectations in a bull market may see their share price rise even further, the bull market premium. Companies reporting worse than expected profit expectations could see investors deserting them in a bear market, the bear market discount. So, we have the perceived v actual risk on the announcement of expected profits and the additional pressure on the share price associated with bull and bear market conditions. Trading onsentiment, otherwise known as unrealistic expectations, can be lucrative.
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Here at Global Investment Strategy UK Ltd, founded by John William Gunn, we continuously invest in new technology. This allows us to provide cutting edge trading facilities, and acompetitive charging structure, maximising trading returns.