A Simple Seasonal Trading Strategy
The end of the month is approaching and a seasonal trading strategy can be used to set up a trade.
The trade is based on the fact that stocks move more in a certain part of the month. This tendency is statistically significant and, in fact, accounted for 100% of the stock market’s gain according to one researcher.
Details of this trade are explained in a paper that can be found in the basement of the library at the prestigious Massachusetts Institute of Technology.
It’s called “A Monthly Effect in Stock Market Prices” and was written by Robert Ariel in 1984.
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Of course, now you can find the paper online.
It’s an interesting paper that was written in a different era. There were no personal computers back then. All of this work was done with expensive mainframe computers, with punch cards that contained the computer code. Statistical analysis was often done by hand.
It was also a time when the academic community was heavily invested in the Efficient Market Hypothesis, or EMH. One aspect of this theory says there is no way to beat the market because there are no identifiable patterns in the market that can be used to generate profits.
This paper showed that patterns do exist in the market and there can be logical reasons for their existence.
The Research Results Reveal a Trading Strategy
Ariel looked at the stock market’s average returns for each day of the month. In essence, he assumed an investor followed a strategy that held stocks just one day. For example, an investor held stocks on only the first day of the month, buying at the open and selling at the close.
Then, he created a portfolio for the second day of the month and the third day of the month and so forth. The results are shown in the diagram below which was taken from the original paper.
At a glance, we can see that there is a bulge in returns in the center of the diagram. This bulge actually lines up with the last trading day of the month and the first half of the new month. Visually, it appears that the second half of the month is inconsequential to returns. Ariel confirmed this.
He found that “the mean return for stocks is positive only for days immediately before and during the first half of calendar months, and indistinguishable from zero for days during the last half of the month.”
This data also revealed insights that could be used to develop a trading strategy.
Ariel found, “during the 1963-1981 period all of the market’s cumulative advance occurred just before and during the first half of months, with the last half contributing nothing to the cumulative increase.”
He also identified several possible causes for this pattern. In the paper, he stated, “a number of stock market advisors claim that a monthly pattern exists. These advisors urge their clients to make anticipated purchases before the start of calendar months, and to postpone planned sales until after the middle of the month to capture the unusually high returns that accrue in the early days of calendar months.”
Ariel also noted in the paper that he was not the first to spot this pattern. Footnotes cite Norman Fosback’s classic book, “Stock Market Logic” as previously testing the idea. Fosback draws on work by Arthur Merrill from the 1960s.
“A Monthly Effect in Stock Market Prices” appears to be the first effort to test the idea in an academic setting. The paper has subsequently been cited in the research of some of the most respected economists. However, the work has been largely ignored by traders.
The lack of attention from traders is not surprising. Traders tend to focus on indicators and chart patterns, ideas that can be applied successfully. The idea of trading the calendar seems to be beyond the reach of many traders although testing does show it can be a profitable trading strategy.
Putting Academic Research Into a Trading Strategy
To implement this strategy, very little work is required. We simply need to identify buy and sell days in advance. Then we select an option that could be used on those dates and we have a complete trading strategy. Trading decisions will be based on the calendar rather than price.
In the chart above, Ariel’s work shows the day to buy jumps out of the picture. The day with the best returns is the day before the end of the month. For November, that will mean buying at the open on November 30, the last trading day in the month.
The sell decision will require some judgement. Returns remain above average through the fifth trading day of the month. It’s important to remember that the chart above shows trading days and not calendar days. They will almost always be different.
Traders could close their positions at any time. Selling on the fifth trading of the month appears to be the way to maximize potential gains based on the work of Ariel and others. For this upcoming month, the fifth trading day of the month is December 8.
The position could be closed at the open or the close on that day. Closing the trade at the end of the day would seem to offer the most potential upside but that may not be convenient for all individuals. Either closing at the start of end of trading will work but the sell decision should be applied consistently.
Ariel tested equally weighted and value weighted indexes in his paper. He found that equal weighting performed best. When he was doing his research, index funds were not yet widely available. Now, we can access a variety of indexes through exchange traded funds, or ETFs.
Guggenheim S&P 500 Equal Weight ETF (NYSE: RSP) offers one way to obtain exposure to an equal weight index.
Call options are available with various exercise prices and several different expiration dates.
When using options instead of stocks, it will usually be best to use an “at the money” option. This is an option with an exercise price close to the current price of the stock or ETF. For example, if the ETF is priced at $98, a $98 call could be bought.
The alternatives could be a $95 call or a $100 call. The $95 call, which would be considered “in the money” and would be more expensive. The $100 call, which would be considered “out of the money” would require a large move in price before it would be profitable but would be less expensive
The next question to address would be which expiration date to buy. There will generally be options expiring within the next month and as far as six months or more into the future. The best one to use depends on the individual trader.
At the money call options expiring sooner will cost less. This could make them preferable for smaller investors.
For this trade, we know exactly when we want to sell, which is December 8. Options expiring on December 15 provides the closest match to that date.
For RSP, the December 15 $98 call option is trading at about $0.70. That could be the best option for trading Ariel’s turn of the month strategy.
In this trade, options allow traders to benefit from a potential rally in stocks with defined risk. These are the type of strategies that are explained and used in TradingTips.com’s Extreme Profits Calendar service. This service uses seasonals as one indicator in its trade selection process.