The week following the announcement of the carbon tax was a choppy one for the stock market, so how could you have used this in your trading?

Immediate impact on the stock market

On July 11, the industries most exposed to the carbon tax were the ones that suffered the biggest falls. The tax, combined with soft US unemployment figures issued on July 8 and higher-than-expected inflation data from China, sent the S&P/ASX 200 down 1.56%, or 72.4 points, to close at 4582.3. Energy stocks were the hardest hit, with the sector shedding 2%, while airlines also suffered.

However, on July 12 the decline was spread evenly across the market with only 11 companies on the ASX 200 making gains. The biggest losses were spread across banking, retail, airlines and energy.

The Australian decline was also lower than the declines of European markets, following rising European debt concerns – despite Greece deflecting default; attention is now on the states of Italy and Spain, with traders questioning whether austerity measures will be an adequate response to their sovereign debt obligations.

Predicted long-term impact

Although the immediate outlook for the market is bearish, with the Westpac-Melbourne Institute Index of consumer sentiment dropping 8.3% from June to July – its largest single-month drop since October 2008, when Lehman Brothers collapsed –the carbon tax will probably have a minor impact on the economy and business in the long-term.

However, an increasing number of economists believe the RBA will raise interest rates in response to price rises, which could result in a challenging environment for retailers as consumers cut their spending.

Also, the Treasury’s forecast that the economy will grow by 1.1% per year from now to 2050 with the carbon tax (as opposed to 1.2% per year without it) may not be sustained.

Trading economic announcements

Economic announcements can be traded if you are fairly certain of the direction the market will take. However, if you are sure that the market will move following an economic announcement, but you aren’t sure of the direction in which it will move and you want to hedge your risk, trading with a spread may be suitable.

Spread trading involves trading both long and short positions of the same size with the same risk reward ratios, and is particularly useful when the market has been trading sideways prior to the economic announcement.

1.  Establish the current range the market is trending in.
If we look back over a 12-month period, Rio Tinto’s closing share price has been trading sideways between 77 and 89 since September 2010, meaning spread trading could be appropriate.

Figure 1: Rio Tinto closing share price 7/07/2010 – 8/07/2011

Looking at the closing prices for Rio Tinto in the weeks before the carbon tax announcement, we can see an upward trend. Having hit a low of 77.3 on June 20, Rio Tinto finished the month at 82.99, rising to 84.35 by July 8, implying that traders may be preparing to go short.

Figure 2: Rio Tinto closing share price 20/06/2011 – 8/07/2011

2.  Place two orders of equal size – one long and one short, with a large risk to reward ratio (at least 3:1).
So you could open a long position on 1,000 Rio Tinto shares $84.35 on July 8 with a 3:1 risk reward ratio – so a limit order at $87.35 and a stop-loss at $83.35. Likewise, you would also open a short position on 1,000 shares at $84.35 with a limit order of $81.35 and a stop-loss at $84.35.

The stop of the long order should always be above the stop of the short order, with enough of a distance between the two to prevent both stops being triggered in case the market slips – if this isn’t possible then this is not the best strategy to use.

In the case of Rio Tinto, the share price fell significantly, losing 1.36% on July 11 to hit $83.20, and another 2.13% on July 12 to hit $81.43. The stop loss of your long position would have been triggered at $83.35, losing you $1 per share.

However, your short position would have remained open until July 13, when the share price closed at $80.95, triggering your $81.35 limit position and securing you a profit of $3 per share for that position, or $2 per share overall, leaving you with a gross profit of $2,000.

This information has been prepared by Jacqueline Pretty at IG Markets Limited (ABN 84 099 019 851) (AFSL 220440). No representation or warranty is given as to the accuracy or completeness of the above information, consequently any person acting on it does so entirely at his or her own risk. IG Markets accepts no responsibility for any use that may be made of these comments and for any consequences that result.