Don't Buy The Rumor, Buy The Pullback

With the merger and acquisition market heating up as of late, it's tempting to try and capitalize on the activity.

But buying on the rumor and selling on the fact may not always be the best strategy.

More times than not, the initial surge that takes place may have traders enter the issue at an inflated price. If the deal immediately falls through or is rejected, it may result in a substantial loss. As with any investment strategy, timing is key to making a profit.

Any investor that tried to play the Jos. A. Bank-Men's Wearhouse saga may have been chopped to pieces and ended up losing money from the eventual merger. The rip in Men's Wearhouse MW took the issue from $45.00 to $58.80 when it was rumored that the company was an acquisition target of Jos. A Bank Clothiers JOSB. But when all was said and done, Men's Wearhouse ended up buying Jos. A. Bank instead, and Men's Wearhouse stock is now trading just under $50.00.

Those who opted for the Jos. A. Bank positions fared much better, as the issue initially rallied from $55.00 to $60.00 and ended up going off the board at $64.50.

Related: Will Bank Stocks Continue To Move Lower On Bad News?

A good example of taking the wait-and-see approach is exhibited in the recent price activity of DirecTV DTV.

It was reported on May 1 that AT&T T had approached DirecTV regarding a potential acquisition. The news that broke during pre-market trading instigated a spike from its closing price on April 30 ($77.60) to $84.04. As the deal failed to materialize over the next few days, the issue drifted lower to almost the exact closing price it was at prior to the announcement. Four days after the initial rumor surfaced, DirecTV briefly traded to $77.50 ($0.10 below its closing price on April 30) but rallied to end the session at $81.74.

Opportunistic investors, acting as if the AT&T rumor were a substitute for downside protection, flocked into the stock on the premise that the deal was still a possibility. This is analogous to the “Bernanke put” with his willingness to support the market with quantitative easing (QE) for as long as needed.

Lo and behold, these investors were rewarded late in Wednesday's session, when it was reported that DirecTV was working with advisers like Goldman Sachs on a potential deal with AT&T. DirecTV, which had already rebounded to the $84.00 level, spiked to $88.57 and ended the session at $88.25. In Thursday's session, DirecTV has retreated to $84.14.

Perhaps all those investors who had loaded up on the issue during its initial pullback are cashing out and putting their profits to work elsewhere.

Another example of this type of price action has taken place in the rumored acquisition of Lorillard LO by Reynolds American RAI. Although it's not quite the textbook example of the AT&T/DirecTV deal, it certainly has similarities.

Financial Times on March 3 reported Reynolds American was eyeing Lorillard as a potential acquisition. Although the company spokesperson declined to comment on the report, the share price of both issues soared. Reynolds American rallied from $50.83 to $53.39 and tacked on another three points to $56.31 the following session. Investors were taking the stance that the takeover would add to the bottom line for the acquirer.

Lorillard reacted positively to the news and rallied from $49.06 to $55.26 during this same time period. When the deal failed to materialize, however, Lorillard drifted lower over the next seven trading sessions to close at $51.01 on March 13. Although it was still $2.00 from its closing price before the rumor surfaced, it attracted investors that believed the company was still in play.

Once again, the Reynolds American bid was acting as a substitute for a put on the issue. From its $51.01 close, the issue began to rally in attempt to recoup its losses from its initial surge to the $55.00 area. Investors that received the early word on the deal took the issue from $55.25 to $57.51 on April 29.

Related: Bankruptcy Can Lead Your Returns Even Higher - Case In Point: American Airlines

When CNBC's David Faber reported on April 30 there had been “a lot going on” between Lorillard and Reynolds American, the issue tacked on another two points to $59.42 in the following session.

Since then, Lorillard has retreated slightly from that level as the savvy investors that bought the pullback are taking profits ahead of an actual announcement of the actual deal, fearful that if the deal doesn't take place Lorillard may return to the level it was trading at before the rumors surfaced.

Playing the rumor mill can produce substantial profits and substantial losses. Since each potential deal has its own unique circumstances, there is no definitive way to capitalize on every deal.

However, if traders can resist the urge to buy the initial spike, keep a close eye on an issue's closing price prior to the rumors surfacing. If the trading action that takes place is anything similar to DirecTV and Lorillard, you just may be able to participate in the deal with a much better risk/reward ratio.