The adage “buy the rumor and sell the news” is a popular one with traders. This phrase is a great illustration of some of the difficulties that traders have with news reports on individual stocks. There is a tendency to overemphasize what traders don’t know (rumors) versus what they do know (news).

[VIDEO] Buy the Rumor, Sell the News

For example, it is not uncommon for a stock to rally after a new product announcement or on pre-earnings whisper numbers and then to decline once the product has launched or the report itself has been released. This post-news decline is common even when the news itself was “good.”

There is a latin phrase; “omne ignotum pro magnifico” (the unknown is perceived to be grand) that summarizes why this phenomenon exists. Traders are more interested in what the future may hold but is still unknown versus what they know right now in the present.

In the video I walked through three examples of stocks that ran up on rumors and then corrected following the release of the actual news. One of those examples was the Palm Pre, a new handset released by PALM in 2009.

From the time of the announcement about the Pre handset until its release in June of 2009 the stock tripled in price. However, once sales began in early June the stock stopped growing and even declined a bit over the next two months. It wasn’t that sales were necessarily bad it was that they were now known.

Buying the rumor and selling the news is not really a trading system but it is a way for you to think about timing risk control. For example, if you own an individual stock that is running up prior to its earnings release (buying the rumor) it might make sense to sell a covered call (selling the news) just before the actual announcement.

If the price of the stock does decline following the actual earnings release the covered call will have effectively removed some of that downside while still leaving some opportunity to profit.

Sometimes trader adages and legends can actually provide some practical wisdom.