It is part of the psychology of trading that many traders stick together – a sort of herd instinct – and quickly all trade the same direction when a move becomes apparent. This is fuelled by the fear of being left out of the profit to be made, and not wanting to ‘miss the boat’. If you stand back dispassionately from this, then there is money to be made from trading the over-reaction.
You will see this sort of effect occur when something triggers a market move. It may be news or a dividend announcement. The market will over-react, and then the prices will come back to a price that may not be the same as previously, but is not as far removed as the surge of the market took it initially.
In effect you are taking a contrarian position, although it is only a very short term one. You need to be ready to see where the market is going, and trade against it as soon as there are signs that the burst of movement is waning. One of the best trading vehicles for taking advantage of this type of instant profit is a Contract for Difference. Instead of having to find the money to actually buy the securities affected, you can trade a CFD for much less, and still profit by the amount the security moves.
The other reason I would recommend a CFD for this strategy is that they are ideally suited. One of the objections raised to using CFDs rather than buying the stock is that there is a small interest charge for holding the position open. When you trade on an over-reaction, by definition your trade will not last long, as you are only looking for the price to stabilize back, so there will be minimal if any interest charges.
How can you recognize that there is an opportunity to trade on an over-reaction? One clue is that the details of what caused the move have not had time to be properly assimilated yet. If it was a report or announcement that runs to hundreds of pages, you will see the gut reaction from the market way before the full consequences of the report are understood. It is likely that a brief summary will cause the market to over-react, whether it is thought that the report is favourable or not. When time has passed and the contents are reflected upon, it is common for the effect to be moderated.
In the longer term, you can expect the market to behave rationally, and price in the news correctly. But in the short term traders are swept along by the market enthusiasm, and will tend to go too far. Using CFDs you do not have to worry if the news seems to be good or bad, as you are able to take either a short or a long position equally easily.
