3 Ways to Trade Seasonality with ETFs
04/18/2014 6:00 am EST
Combined with technical analysis and risk management, traders can use seasonal tendencies to help find entries, exits, and the best times to trade to maximize profits, says Cory Mitchell of ETFdb.com and VantagePointTrading.com.
An expanding number of ETFs, combined with the computational power to find seasonal tendencies in the stock market, means ETF traders can utilize these tendencies for trade selection and timing. Seasonal tendencies occur for varying reasons, such as an elevated mood heading into Christmas, seasonal changes, or short-term phenomenon such as one day of the week performing worse or better than others.
Below we take a closer look at three seasonal tendencies you can use to your advantage.
Ever heard “sell in May and go away?” This trading phrase is derived from the Stock Trader’s Almanac disclosure that there is a tendency for the stock market to perform better during the six months of November to April than the six months between May and October. Between 1950 and 2011 the average percent change in the best six months was +7.5%, while the gain in the other six months (May 1 to October 31) was only +0.3%.
Sy Harding introduced a way to trade this seasonal pattern in his book, Riding the Bear. The basic concept is to use a MACD to find entry and exit points that align the six-month seasonal tendency. A buy entry occurs when the MACD makes a move into positive territory (above zero line), or the MACD crosses above the signal line near the start of the bullish cycle. A sell occurs when the MACD moves into negative territory (below zero line), or the MACD crosses below the signal line near the start of the bearish cycle.
Figure 1 shows the strategy applied to the SPDR S&P 500 ETF (SPY).
Signals may occur slightly before or after the “official” start and end dates of the six-month cycles. The cycle or signals are not infallible, though; sometimes the best six months will not produce a profit, and in other years the historically bearish six-month period may outperform the historically bullish six-month period.
20-Year Seasonal Study of S&P 500
A seasonal study looks at how the market performs in given months over a long period of time. This highlights tendencies in certain months and also highlights different points of the year that are historically favorable for stock purchases or sales.
Figure 2 shows a 20-year seasonal chart of the S&P 500. Common high and low points for stocks are marked on the chart.
This seasonal study also confirms the six-month cycle from the previous section. November through the end of April usually sees more of a rise, while May until the end of October shows a tendency to stay flat over the last 20 years.
NEXT PAGE: Monday Blues and Tuesday Turnaround|pagebreak|
While 2013 was a bullish year for the S&P 500, and therefore most buy strategies would have worked, the major high and low points in Figure 2 could still be used to make trades in the Core S&P 500 ETF (IVV).
While the high and low points of the year are approximations, they did a good job of capturing major price swings in the ETF through most of 2013.
Monday Blues and Tuesday Turnaround
There is also a definite pattern to days of the week when tracking the broad market’s performance—some days far outperform others. According to the Stock Trader’s Almanac, since 1980, Monday has been the worst-performing day, barely edging out a positive return over this period. Tuesday is the best-performing day, followed by Wednesday, and Friday is the third-best performer of the week, moving up 25% of the time.
Short-term traders can plan purchases and sales based on this phenomenon. During an uptrend, buying near the Monday close and holding until near the close on Wednesday takes advantage of the depressed prices on Monday, as well as the common jump that occurs on Tuesday and Wednesday. Ideally, long positions shouldn’t be held through the weekend, unless the trend is very strong, or you can hold through the likely sluggishness on Monday. Tuesday has a tendency to be especially strong if Monday was down more than 1%.
The same approach can be applied when stocks are broadly heading south; when the equity market is in a downtrend, taking short positions on Friday and holding until late in the session Monday takes advantage of Monday’s weakness.
These types of patterns have occurred historically, yet in any given year, week or day the tendency may not occur. All the tendencies are based on studies going back to 1950 (or earlier) to the current. Over this period, there was an upward bias in the market, which is reflected in the results. Most of these tendencies indicate positive returns, yet that may not always be the case. For example, Tuesday may still perform better than Monday, but during a downtrend all the days of the week may see negative returns.
Therefore, seasonal tendencies should never be relied on exclusively, but rather combined with other forms of analysis and risk management to find viable entry and exit points. Seasonal tendencies provide an approximate time window of where trades have a high probability of working out, but each trade still needs to be within risk tolerance levels and if the seasonal pattern doesn’t work out, you’ll need an exit plan.
The Bottom Line
Seasonal tendencies provide a unique view of the market, showing the historical probabilities of certain price occurrences or time. Combined with other technical analysis methods and risk management tactics, ETF traders and investors can use seasonal tendencies to aid in finding entries, exits and choosing the best times to trade.