“Buy the rumor, sell the news” is a phenomenon that happens in most markets, particularly financial markets. Sometimes traders turn this idea into a trading strategy that draws upon on what they believe will occur in a forthcoming economic report or event. This speculation constitutes the rumor phase of the strategy when the trader buys an asset. Once the awaited event passes or the report is released, the proverbial news has been made public. The trader then dumps their positions and the market moves.
A Lesson in ‘Rumors’
In markets outside of the foreign-exchange (Forex), traders and investors alike often buy based on anticipated future cash flows. This means if a company is expected to provide more revenue to shareholders than previously thought, traders will buy the stock quickly to take advantage of increased dividends or stock price. However, this behavior also applies to Forex, but instead of cash-flows, traders often act on anticipated interest rate changes.
Investors who apply this strategy tend to seek out undervalued markets. When potential news or information, which serves as a rumor, suggests that an asset may produce more future cash flows, it may be worth more in the next few weeks or months. Investors will buy that asset up to the point where it is no longer undervalued.
If the rumor is false or the market over buys the asset such that it is no longer undervalued, but potentially overvalued, than an inline newsprint slightly below expectations will rightfully cause a selloff. Only a surprise news event that surpasses the anticipated rumor will cause the stock to remain at levels before the news event or potentially higher.
Implications of ‘Buy the Rumor Sell the News’
One of the largest frustrations for traders is created by buying something you know to be strong only to see it sell off and lose value. There is a mental bias known as recency bias; this idea was highlighted in Daniel Kahneman’s “Thinking Fast and Slow.”
In such an instance, one trader reacts slowly to news while other traders act as soon as the rumors come out. Such slow-to-act traders often provide the liquidity for in-the-know traders to take advantage on the now confirmed or disappointing news release.
Take-Away
When a positive news event comes out and the price rises, entering on that positive news release can potentially be the worst possible time to enter the market. That is the time when everyone else who bought the stock at the lower price may be getting out of the market to reap a profit.
There are few things in Forex trading more frustrating than being the source of liquidity for other traders. One of the best ways to avoid this fate is to wait for a retracement, a brief reversal in price direction, after a good news event to buy at a better price.
