How to Trade the January Effect
Traders often refer to stock market phenomena to help them understand why price movements occur with seasonality. The January Effect, coined by Sidney B. Wachtel, simply refers to the belief that the direction of the market can be determined as a whole, for the year, based on the return of January.
Why Does the January Effect Occur?
You must first revisit the calendar to the prior December. Often, the month of December has a tendency to be more volatile in the first few weeks leading into the “santa rally”.
Amongst cryptocurrency traders, and being that the market is relatively young, many traders subscribe to the idea that the January Effect may be the cause of recent rallies in crypto early 2019, despite recent 80-90% declines from all-time highs.
Large portfolio and mutual fund managers tend to operate on a quarterly basis. Near the end of year, managers often sell underperforming positions to improve the appearance of quarterly and year end performance.
When it’s time to present the shareholders with the fund’s result, they “window dress” the fund’s success by removing positions that don’t look appealing.
Managers like to replace the underperforming losing positions with stocks that are expected to produce short-term gains. They may also take investments in products like precious metals or currencies to disguise their holdings.
Over the short-term window dressing can bolster portfolio returns, however over the long term, window dressing typically results in negative yields.
It’s interesting that fund managers typically window dress large cap positions, yet the January Effect tends to effect small caps more. In recent years, the January effect’s track record is roughly 50:50 versus the S&P500 ($SPX).
Tax Loss Selling
Commonly, the January Effect is thought to occur as a result of tax loss selling. Investors frequently exit stock trades/positions near the end of year to claim capital losses. The free capital from those positions can be easily invested beginning the following year.
If large tax selling drives prices down, longer term investors may find stocks more attractive at cheaper prices, thus inviting the temptation to buy them.
A common argument against tax loss selling as being the catalyst for the January Effect is the prevalence of tax deferred retirement accounts, which may reduce the reasoning to cut losing positions at year’s end.
January Effect Trading Benefits
What other reasons may provide a benefit for trading during the month of January?
- Predictable seasonal market fluctuation. Traders can possibly take advantage of seasonal fluctuations to define better directional entries/exits.
- Optimistic losses. By closing out losing trades at the end of the year, you may be entitled to certain tax benefits…and you now have free capital to invest/trade in ideally more successful trades.
- Year-end bonuses. If you’re job offers a year end bonus, this means you and other similar employees can reinvest their bonuses into the market in January.
5 Steps to Profiting from the January Effect Trading the Stock Market
#1 Chose Small Cap Stocks
Because the January Effect is more weighted towards small-cap stocks, traders with smaller accounts stand to benefit because they have the capital to trade less pricey stocks.
Since small cap stocks are typically less liquid, the January Effect is likely more pronounced. According to Mr. Wachtel, in Certain Observations on Seasonal Movements in Stock Prices, small caps traditionally outperformed markets during January, specifically during mid-month.
#2 Choose a Direction
Decide on either a short or long position. Opportunities exist in both directions depending on your market timing (December vs January), as well as your dependence on small caps vs large cap stocks. There’s no reason to get fancy.
If you typically focus on short position trading, then stick to your short position criteria that could take advantage of the January Effect.
#3 Buying and Selling
Your trading can only be as good as it’s entry and exit, neither of which are more important than the other. Your entry is the price in which you decide to buy a stock or enter a position.
Whatever your trading strategy, perform diligent research and analysis before executing a trade. If you prefer technical analysis, this may require you to view a stock’s past performance over many days, months, or years. Plan your exit.
Your exit is equally important because it determines your profitability. It’s hard to get out of a trade profitable if you never sell it…Trading without a plan, is planning to fail. This means that you should also be willing to cut a losing trade.
Not every trade is going to be successful, and your mindset should be, “losing trades are just part of the trading business.”
#4 Reduce Your Risk
Narrow your focus. Learning how to reduce risk is one of the most important skill sets a trader must develop to become consistently profitable over the long term.
By developing a strategy that focuses on fewer strategic trade setups, you can trade more focused. More focused trading can also deter overtrading. It may also be advantageous to maintain a trading journal.
This way, you’ll be able to track your trading progress as well as focus in on what strategies and setups are best for your trading style.
You should also avoid oversizing. Taking a position size far greater than what is ideal, will destroy your equity by triggering catastrophic losses that you cannot overcome. You may hold the belief that you need to take a large position size to produce hefty gains.
This is a misconception. Big size equals big risk, and requires your trade to be correct quickly, otherwise you’ll likely blow out your account…which is the last thing you want to do …which is also why it should be the first thing you attempt to prevent.
If you take smaller position size, the trade setup effectively has a greater chance to work out profitable, because your account as more wiggle room. Sudden price fluxuations will devastate your account balance should you be oversized. Trading is a long term grind. Managing risk is your number one priority.
#5 Find Opportunities with a Stock Screener
There are plenty of free stock screening programs available. I particularly like using Finviz for quick scans where I can save interesting criteria for future scans. Whichever scanner you decide to use, it should include the following:
You should be able to analyze your chart patterns, such as support and resistance levels, wedges, etc… using multiple time frame settings as well as your choice between candlestick, line, and bar charts. Having more choices effectively allows you to make the most educated decision about entering and exiting a trade.
It’s also important to keep up with news events that could drive price movements in the near future. Notice highlighted in red, Finviz posts important economic news that may affect stocks.
Headlines pulled from news outlets and social media can hit before more traditional televised news outlets. It’s sometimes worth more being aware of news that can create volatility. No matter the source, it should go without saying… verify your source, especially if you’re going to allow news to affect your decision making.
The January Effect is a seasonal stock and securities phenomenon that traders can conceivably use further bolster their advantage when defining trading plans amid the finish of one year and the beginning of the following year.
In any case, it’s pertinent to remember that the January Effect offers no assurances with trading decisions: You should perform your own due diligence as research is essential before executing any trade.