Suppose a trader expects that an upcoming economic report or world event will alter the price of their asset in a given way. When the trader buys an asset-based on this instinct, that is the rumor phase of the strategy. Once the event passes or the report is released, the news has been made public. The trader then dumps their positions, and the market moves. Investors who use this strategy tend to seek out undervalued markets. When potential news or info suggests that an asset may produce more future cash flows, this is the “rumor.” The asset is rumored to 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 overbuys the asset so that it is no longer undervalued, then news that falls slightly below expectations will cause a selloff. Only a surprise news event that beats the rumor will cause the stock to sustain its valuation. If a surprise news event is positive enough, it could potentially push the value even higher.
Example of Buy the Rumor, Sell the News
A common example of buy the rumor, sell the news in the stock market is trading based on the expectation on a company’s quarterly earnings report. Perhaps there’s a rumor that a company is expected to provide more revenue to shareholders than previously thought. In that case, traders will buy the stock quickly to take advantage of increased dividends or stock prices. Once the company has its earnings call or makes its results public and the stock rises on strong revenue, the traders will sell their shares to turn a profit. This behavior also applies to forex, but instead of cash flows, traders often act on anticipated interest rate changes. Here’s how the rumor works in forex. When a central bank raises interest rates, it often signals a strong economy. In that case, forex traders expect the currency’s value to increase. Suppose a forex trader catches wind of a plan for a central bank to raise interest rates. Based on that rumor, the trader may buy up the corresponding currency. Next comes the news. When the central bank actually moves the interest rate, the forex trader will watch as the news pushes the currency’s value higher. Once the currency hits a high enough value to earn the trader a nice profit, that trader will “sell the news” and trade the currency at a higher price.
Disadvantages of Buy the Rumor, Sell the News
Not Accurate
No one can time the market with absolute certainty and buy the rumor, sell the news trading strategy is no different. There can be a number of reasons why this strategy could fail to yield a profit for traders. Another example could be that the new itself may not live up to the expectation. For example, in a bear market a company that beats expectations in its quarterly earnings may still see its stock price fall because the good news may not have lived up to the hype.
Speed of Decision Making
If you’re a trader, one of your big frustrations is buying something you know to be strong, only to see it lose value in a sell-off. There are many reasons why this could happen, but it could come down to differences in the way traders process information. One trader may take time to digest the news before making a trade, while other traders act quickly as soon as the rumors come out. Traders who are slow to act often provide liquidity for those who are in the know. Those traders then take advantage of either the “rumor” or the “news.”
The Bottom Line
When a good news event comes out, and the price rises, entering on that good news release can potentially be the worst time to enter the market. That is when everyone else who bought the stock at the lower price may be getting out of the market in order to reap a profit. There are few things in trading more frustrating than being the source of liquidity for other traders. One of the best ways to avoid that fate is to hold out for a price trend reversal after a good news event. It can be more to your advantage to wait for a brief reversal in price direction and buy at a better price.
