Buy the rumor, sell the fact – A technical approach to trading

Summary: Buy the rumor, sell the fact is a well known phrase using in trading circles. By combining the technical indicators and accounting for the hype surrounding an event, this article outlines how traders can mix fundamental and technical analysis to enter at the strongest phase in a trend.

Buy the rumor, sell the fact is a phrase that is often quoted by traders, spanning across all markets; stocks, futures, currencies and even bonds to an extent. The principle is base on the fact that price tends to rise (or fall) in speculative moves ahead of a big event. Typically, after the news is released, price tends to sell off, with the selling pattern starting a day or a few hours ahead of the event as speculative traders tend to exit their positions.

While previously, the Buy the rumor, sell the fact was largely confined to economic releases such as inflation, GDP, and unemployment, in recent times this principle has also found its basis in central bank meetings. After the 2008 global financial crisis, central banks with their monetary policy easing and rate cutting cycles have become an increasingly frequent phenomenon in the markets. Therefore, such central bank policy decisions and especially the meetings where the basis for a policy change is high offers some of the best opportunities for traders.

Despite the potential opportunities that are brought by this phenomenon, it is by no means an easy task. To prepare for the trading opportunities, the trader needs to have a firm understanding of the underlying factors. Combining this information with technical analysis can be a great way to find lucrative short term trading opportunities.

 

Examples of Buy the rumor, sell the fact

In the first example (Figure 1) we take a look at the Bank of Japan which has been in the spotlight since the start of 2016. With inflation far from the central bank's inflation target of 2.0% and with the BoJ already neck deep in monetary easing; the strengthening yen has been a worry for Japanese officials, both the government and the central bank.

In April, the environment was right as the markets started to buy USDJPY in anticipation that the BoJ would expand its policy easing measures. In figure 1, below between the periods of April 18 and into the April 28 BoJ meeting, we can see how USDJPY posted a strong rally.

Fig 1: USDJPY rallies over 3.39% on speculative buying and sells off almost immediately

This rally was typical; buy the rumor trade as traders rushed into buying the dollar in hopes that the Bank of Japan would cut rates into negative. The rally picked up steam when a weak before the BoJ meeting, Bloomberg published an article citing unnamed sources of potential easing from the central bank. By market closing time on April 27, USDJPY posted 3.39% gains since April 14, or 2.14% since the Bloomberg article.

When the BoJ met on 28 April and failed to act as expected, USDJPY saw a massive sell off, with the previous week's gains being wiped out in a few days.

The second example can be taken from the ECB’s monetary policy meeting in December 2015. In the run up to this event, EURUSD fell sharply as various ECB officials came out dovish. The markets expected that the dovish speeches would result in the ECB expanding its monetary policy, which causes speculative sellers enter the market. EURUSD fell almost 6.80% since mid September into the December meeting. However, when the ECB failed to meet market expectations, the euro surged 3.50% on a single day, erasing the previous month’s losses by half in a single day.

Fig: 2 EURUSD falls over 6.80% in speculative selling, only to recover 50% of the losses after the ECB falls short of market expectations

If there is one main take away from the above two examples from among the many, it is the fact that traders can enter into the trends mid-way while the momentum is strong. Likewise, when the final event fails to match expectations, it exposes a huge risk in the opposite direction.

 

Applying technical analysis to the Buy the rumor, sell the fact trades

Combining technical analysis to the above trading opportunities can be a great way to combine the fundamentals as well. One of the best ways to find good trading opportunities is to use an oscillator which signals overbought and oversold levels alongside trend indicators. By combining trends and the OB/OS indicators, traders can stay with the general crowd while keeping their profit targets at reasonable levels. Think of it as riding the surf when the trends are the strongest. Divergence is another important aspect of tying into these set ups.

Revisiting the above two examples, but with technical indicators, we can get the complete picture. In the technical analysis context, we will look at two moving averages (20 and 50) on a 4-hour chart and use a 14,3,3 Stochastics oscillator. The trading rules will be simple. Sell on a hidden bearish divergence in a downtrend, and buy on a hidden bullish divergence in an uptrend.

Trends can be identified by looking at price’s high and low as well as the EMA’s acting as a trend indicator tool.

In the first example, the USDJPY trade set up is shown. After the uptrend is confirmed, based on the fact that price was posting higher lows, confirmed by a bullish divergence and an eventual 20/50 EMA bullish crossover, we spot a hidden bullish divergence and enter long. The targets are set to 1:1 and 1:2 risk reward set up, but of course, traders can set intermediate levels and book profits accordingly. The first target at 1:1 RR was reached, followed by another quick run up before price reversed shy of a few pips away from 1:2 RR target.

While the second target was not reached, an astute trader would have already closed out most of their positions while leaving a few positions running with no risk on the table or even locking in some profits.

Fig:3 USDJPY – Technical trading into the BoJ event in April

The next chart below shows an opposite set up in EURUSD during the December policy meeting.

Here, after the downtrend is confirmed by lower high and low in price and a bearish 20/50 EMA positioning, we spot a hidden bearish divergence. Short positions are taken here with a 1:1 and 1:2 RR set up, both of which this time are reached.

Fig 4: EURUSD Technical trading into the December ECB meeting

From the above examples, we can summarize some basic guidelines for trading the Buy the rumor, sell the fact trade set ups.

1. Ascertain how important an event is. The more hype there is for an event, higher the chances that the speculative trend will be stronger

2. Using the technical indicators, time your trades so that your risk is kept to a minimum

3. Book profits regularly and mind the stops

4. Close out all positions, regardless of how the trade is performing a few hours ahead of the main event

For those interested to apply this methodology and want to check on other markets, some examples include the OPEC meeting earlier this year in Qatar, the BoE policy decision earlier in June this year to name a few. Upcoming events include the BoE’s August policy meeting where the market expectation for policy easing runs high. You also have the RBA meeting in early August where speculation for a rate cut is high.

 

What are the risks with this trading approach?

While the set ups might sound good, traders should also understand the risks that come along. Here are some risks that traders should pay attention to.

1. In speculative moves ahead of a big event, price can fluctuate on even the most smallest of rumors that are either tweeted or quoted by various financial media

2. Use Google alerts to find/scan for articles related to the event. For example, if you are following a BoJ policy action, then set the alerts for USDJPY, JPY, Yen, Japanese yen, Bank of Japan, Kuroda

3. Try to find some reputable local sources. For example, if you were tracking the ECB policy action, then pay attention to local news sources such as France24, Euronews.com and so on, so that you can get access to any breaking developments on the topic of your interest

4. Use CNBC.com and Bloomberg.com and your main source of the ‘Rumors.’ As these news sources are widely followed, any articles, despite their validity can move the markets strongly.

5. Last but not the least, always pay attention to your position and risk management