'Buy the Rumor, Sell the News' Forex Trading Strategy
The decision to buy a security based on rumors and then sell it when news breaks may sound like a precarious plan, but it can also be a clever one.
"Buy the rumor, sell the news" is a phenomenon that happens in most markets, particularly financial markets. Traders sometimes turn this idea into a trading strategy that draws upon what they believe will occur in a forthcoming economic report or event. When the trader buys an asset based on this speculation, that constitutes the rumor phase of the strategy. 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 market (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 prices. This behavior also applies to forex, but instead of cash-flows, traders often act on anticipated interest rate changes.
Investors who use this strategy tend to seek out undervalued markets. When potential news or information 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 (and potentially becomes overvalued), then a news story or financial report that falls slightly below expectations will rightfully cause a selloff. Only a surprise news event that surpasses the anticipated 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.
An Example Applied to Forex Trading
A common forex scenario that produces both rumors and news concerns a country's central bank and its interest rate policy. When a central bank raises interest rates, it typically signals a strong economy, and forex traders expect the currency's value to increase.
If a forex trader catches wind of a plan or otherwise believes a central bank will raise interest rates—the "rumor"—that trader may buy up the corresponding currency. Then, when the central bank actually moves the interest rate—the "news"—that 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.
Implications of 'Buy the Rumor Sell the News'
One of the primary frustrations for traders is created by 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. This idea was highlighted in Nobel Prize-winning economist Daniel Kahneman’s book, "Thinking, Fast and Slow."
In such an instance, one trader takes time to digest the news before making a trade, while other traders act impulsively as soon as the rumors come out. Slow-to-act traders often provide the liquidity for in-the-know traders to take advantage of either the "rumor" or the "news."
The Bottom Line
When a positive news event comes out and the price rises, entering on that positive news release can potentially be the worst 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 after a good news event—a brief reversal in price direction—to buy at a better price.