Buy on rumor – sell on fact

If you have been investing for any length of time, you have probably heard the saying: buy on rumor and sell on fact. This old saying basically means that the price of a stock will tend to run up prior to a quarterly announcement and then drop immediately afterward. This drop can be gradual or fairly drastic. In the best of cases, the stock will actually increase after the “facts” are widely known.

Earlier this week, Apple Inc. [stckqut]AAPL[/stckqut] announced their revenue for the latest quarter. By most accounts it was a great quarter having surpassed their revenue attainment for any quarter since the company’s founding. However, the stock dropped immediately on the day after the announcement! This is because the analysts that follow Apple thought that the company would do better on some of its products, than it actually did. The analysts were slightly incorrect in their predictions and therefore the stock dropped several percentage points after what many people would think was a great quarter.

This is a perfect example of buying on the rumor of great revenue in all products and selling after the facts of the revenue are well know. It is quite likely that Apple’s stock will cover this short-term loss but the change in direction of the price could have hurt your portfolio. ¬†Also, this is just one recent example and other companies have seen their stock price drop even farther on good news that is not good enough.

So how do you protect yourself from these sudden drops?

  1. You should know the date of the quarterly updates for your major holdings. If you see the stock moving up immediately before the announcement, you may want to take some of your earnings off the table and lock in your profits. You can always jump back into the stock if the price continues to move up.
  2. You should setup your account to automatically get you out of a stock if it has a major price move. This should be standard practice for all of your holdings as it will protect you in the event that news breaks that adversely affects your holding or the market in general. Your broker should have a way of allowing you to do a conditional trade. A conditional trade should be set up like this: Sell 100 shares of AAPL as a market order if the price of AAPL drops over 7% in a single day. This order is different than a trailing loss order as it is only looking for a rapid drop in a single day rather than just a gradual decline over the course of time. You could have a trailing loss order of 10% but the conditional order will get you out faster if the stock is moving very rapidly due to bad news.
  3. If you are watching the quarterly announcement of your holding, you can easily check what the after hours trading is doing based on the news. If you see the stock has dropped, then you can let your conditional order save you. If you think the reaction is incorrect and you want to weather the short-term loss, you can log into your account in the evening, cancel your conditional order, and then replace the conditional order at about noon the following day after the market has stabilized. Most bad news will take place in the first hour of trading if it is just going to be a quick correction. If the price is still rapidly dropping at noon then you may want to exit the stock as well, as the news is probably worse than you thought.

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