Trading Santa Claus

Data on the phenomenon dubbed the Santa Claus rally suggests that an annual market anomaly might be profitably exploited. However, doing so may require a set of rules for effective execution. To establish useful rules for how to trade the six-day stretch (four days before the end of the year and two days after), it would be worthwhile to understand a few things about how the market typically behaves this time of year compared to any other period.

The chart below is a seasonal look at the S&P 500. This type of chart averages out the price action over a given period (in this case 20 years) and shows how the index performed at any given point in the year. This chart shows that the last weeks of the year, on average, typically feature positive moves. Notice that, in the weeks of the subsequent year, stocks turn down in about the middle of January. 

People who like to set their investing strategies and forget them for extended periods will recognize that they may have to endure a bit of negative fluctuation during this period. But traders with a shorter-term focus will recognize the need to have rules for taking profit.

Thursday’s Chart Advisor edition explained that the market closed higher 65% of the time over the past 26 years in the modern ETF-era of stocks (the time since the inception of State Street’s S&P 500 index-tracking ETF (SPY). This means that there were nine years where the market left a lump of coal for investors instead of bringing the Santa Claus rally.

The chart below compares the down moves of those nine years. This is a small sample size, so it is important to note that these occasions are not fully representative of all that could happen in a six-day stretch of trading. Consider that the typical variation for any given year is about 3.5% during those six days, the largest variation for any six-day stretch over the past three decades has included a downward move of over 27%. That’s not the kind of drawdown most investors would enjoy.

A simple technique for ensuring against a catastrophic loss during these six days would be to simply use a stop loss. A 6% stop loss would have kept any investor in the market through all nine negative years and given them a chance to see stocks rebound. However, a 5% stop may actually be more optimal. (Shameless teaser: for reasons why, be sure to watch for the next Chart Advisor edition.)

The diagram below lays out a simplified flow chart for the best rules in trading the Santa Claus rally. The rules are actually quite simple. First, buy the S&P 500 index using an ETF or mutual fund on the day after Christmas. Second, set a 5% stop loss order, or a mental note to close the position if it drops 5% in a week. Third, if the trade is positive on the second day of the new year, take profit. Finally, if the trade didn’t drop 5% but also hasn’t seen profit yet, then hang on, as chances are good that a profit-taking opportunity will come along before the end of January.

Observing the Santa Claus rally is one thing, but actually trying to profitably trade the phenomenon is another. A useful set of rules for doing so includes considering a stop-loss level and having a plan for what to do if the trade is neither profitable nor stopped out at the end of the six days.

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