According to the idiom "Buy the Rumor, Sell the News", investors make trading decisions based on a prediction before official news becomes available. This helps them to profit but also has potential risks.

"Buy the Rumor, Sell the News" is a phenomenon that occurs in most markets, but most commonly in financial markets.

Professional traders on both stock and forex markets predict value moves based on what they believe will come true: forecasts about upcoming financial reports or economic events.

When they buy stocks/currencies based on such prediction, it is the "buy the rumor" phase. Once an official report is released or an event they expect to happen, the "rumor" will come true. This is when a trader sells the asset to the market.

"Buy-in" when at the "rumor" stage, and "sell" when the prediction becomes "truth" sounds risky, but it's a fairly smart strategy and has been adopted by investors for a long.


Lessons for 'buying rumors'

Traders, as well as investors, often place buy orders based on predictions of future cash flows. This means that, if a company they forecast has a higher turnover than previously expected, traders will quickly buy that company's stock to take advantage of the dividend increase or stock price. This behavior also applies to forex, but instead of cash flow, traders often make decisions based on predicting a rate change.

Investors who use this strategy tend to look for undervalued markets. When there is potential information suggesting that a stock can generate more cash flows in the future: the stock is rumored to be worth more over the next few weeks or months. Investors will buy the stock until it is no longer undervalued.

If the rumor is false or the market overbought that stock makes it no longer undervalued or even overvalued, then the value of the stock according to financial reports or news If officially released just a little lower than expected, the "rumor" will not go as expected and cause a sell-off of the stock in the market. At this time, the "rumored" investor suffered heavy losses. Only when the value of a stock according to the "truth" is declared suddenly surpasses the predicted rumor, that stock can maintain its valuation as a "rumor". If the "truth" is unexpectedly positive enough, the stock will be able to push the value even higher.

Applies to the foreign exchange market

A common scenario in the trading market to adopt the strategy of "buy the rumor, sell the truth" relates to the central bank and the bank's interest rate policy. When a central bank raises interest rates, this often signals a strong economy and traders expect the value of the currency to rise.

If a trader catches on to a plan or believes a central bank will raise interest rates then that trader can buy the corresponding currency - the "buy rumor". Then, when the central bank actually raises the interest rate (the "truth"), the trader will watch as this "truth" drives the value of the currency higher. Once a coin reaches a value high enough to make a good profit, the trader "sells the truth", selling the coin at a higher price.


As an example, there was a trader who heard rumors that the Bank of England (BoE) was about to raise interest rates, leading to a possible increase in the value of the British Pound (GBP). Predicting that the announcement will happen, traders immediately make decisions to trade on popular currency pairs like GBP / USD or GBP / EUR.

If the "rumor" is correct, and the Bank of England actually raises interest rates, investors can start a cash flow right in the "rumor" period. By doing so, they will reap greater profits than those making decisions close to the "fact" that the Bank of England announced interest rate hikes.

The implication of the maxim "buy rumors, sell the truth"

A major disappointment for traders is buying stocks/currencies they believe will rise, but lose their value during the sell-off. There are many reasons for this failure, but it can be due to the difference in the way traders process the information. This idea was featured in the book "Fast and Slow Thinking" by Daniel Kahneman, an economist who won the Nobel Prize in Economics in 2002.

As the book explains, some traders need time to review the news before making a trade, while others act as soon as the rumors appear. Slow decision-makers often provide traders with high liquidity to take advantage of either the "rumor" or the "truth" phase.

Conclude

Entering the market at the "truth" stage and the stock / foreign currency has actually gone up may be too late. That is the time when those who quickly buy at low prices can withdraw their capital from the market to make a profit. What is more disappointing when it comes to being a source of liquidity for other traders.

One of the best ways to avoid this failure is to wait for the market to "calm down" again after a period of positive "truth" - prices turn around in a short period of time - to buy at good prices.