"Buy the Rumor and Sell the News"
'Buy the rumor, sell the news' is something that happens in most markets, particularly financial. Sometimes traders trade based on what they believe will occur in a given economic report or event (the rumor). Once the event passes or the report is released (the news), they dump their positions and the market moves.
In markets outside of foreign-exchange, like stocks, traders and investors alike will often buy based on anticipated future cash flows.
Broken down, this means if a company is expected to provide more revenue to shareholders than previously thought, traders will look to buy the stock quickly to take advantage of increased dividends or stock price. However, this behavior also applies to FX, but instead of cash-flows, traders often act on anticipated interest rate changes.
An especially helpful image is to think of investors as piranhas that seek out any undervalued market. When potential news, also known as a rumor, starts to surface to show that an asset may produce more future cash flows are be worth more in the next few weeks or months, those 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.
There is a mental bias known as recency bias; that was highlighted in Daniel Kahneman’s Thinking Fast And Slow, that described traders find yesterday’s news.
In this event, a trader acts slowly to news the other traders, and now commonly algorithms had acted on as soon as the rumors came out. It is unfortunate because the slow to act traders often provide the liquidity for the algorithms or in-the-know traders to exit on the confirmed or disappointing news release.
Have you heard the saying, ‘if something is too good to be true, it probably is’? It might be helpful to think of this when trading because when a positive news event comes out and the price reacts positively, entering on that positive news release can potentially be the worst possible time to enter the market. It is because that is the time when everybody else that brought the rice previously is getting out of the market.
There are few things in FX trading more frustrating than being the liquidity for successful traders. We want to help you avoid this fate, and one of the best ways to do this is often to wait for a retracement after a good news event to buy at a better price. If you buy on the extension after the news announcements, you are likely not getting a good price and might be entering at the worst possible time.