Seasonal Analysis: Offering a Statistically Significant Advantage to Traders
Some traders will base trading decisions solely on the calendar. These are traders that employ seasonal analysis in their work. Seasonal analysis involves identifying the time periods when a market is most likely to rise or fall and placing trades based on that calendar tendency.
A well-known example of seasonal analysis in the stock markets is to "sell in May and go away." Tests have demonstrated that stocks tend to underperform in the six months beginning with May and investors would get better returns by buying at the end of October and selling at the start of May than they would by holding stocks over the entire year.
Seasonal analysis probably originated in the grain markets where the calendar dictates the planting and harvest seasons. With corn, for example, farmers will plant the crop in the spring and bring it to market in the fall. The increased supply at harvest time would be bearish for prices and traders could take advantage of this by shorting corn and other grains as the harvest season approached.
In stocks, there are also trends driven by the calendar. Many retirement plan contributions are made at the end of the month and stocks show a tendency to rise in the first week of each month.
Another seasonal trade in the stock market is known as the January Effect. Tax-loss selling in small-cap stocks can be seen in the tendency of these stocks to underperform the market in December. Investors tend to repurchase these stocks in January and small caps generally outperform large caps in the first month of the year.
The January Effect has been observed in the stock market since the 1920s and is one of the seasonal strategies that has been widely studied by the academic community. Their conclusion is that it works and offers a statistically significant advantage to traders.
How Traders Use It
Traders can use seasonal analysis as a stand-alone trading strategy. They could, for example, buy an aggressive equity ETF at the close on the last trading day each month and sell it on the close five days later. This would be a way to take advantage of the beginning-of-the-month bullish pattern seen in stock prices. Futures traders could consider shorting a corn futures contract in the third quarter of every year, a strategy that would deliver winning trades about 65% of the time.
Seasonal analysis could also be included as one of the factors used in a trading strategy. In a seasonally strong period, like the six months from November through April, traders might take only long trades, and then take short positions only in the other six months of the year when there is seasonal weakness.
Seasonal signals could also be taken only when confirmed by a trend-following indicator like a moving average or an oscillator such as the relative strength index (RSI). To do this, seasonal buys would only be taken if the price was above a moving average or if the RSI was at an oversold level.
Why It Matters To Traders
Seasonal patterns have been shown to work well in the stock market, as well as in futures markets. They are considered to be anomalies to the Efficient Market Hypothesis, which means that seasonal trades pass academic tests for statistical significance and are likely to continue working well in the future.
Traders can use seasonal analysis to develop specific trading strategies and enhance their trading performance.