Trading Strategy: Monthly Seasonality Mash Up

In this report, I’ll combine the two monthly seasonality observations I talked about recently, options expiration week and the turn of the month into a fairly effective strategy using nothing other than the time of the month.

Historically, the beginning and end of the month, as well as the week (mid-month) leading up to options expiration have been bullish, and the time in between, bearish. Conceptually, the average month could be thought of like a ‘W.’

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The following graph shows the results of a portfolio trading the S&P 500 long-only (red) using the combined rules from the two previous reports - long the first three and final four days of the month and the week leading up to options expiration – versus buy and hold (blue) from 1988.

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[logarithmically-scaled]

And for the number lovers:

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Over the last 20+ years, the combined monthly seasonality strategy has outperformed the market in terms of absolute and risk-adjusted returns and significantly reduced downside volatility, while only exposed to the market a little over half the time.

This test was frictionless (no transaction costs or slippage) and ignored return on cash, but these results could be very easily duplicated using actively-traded mutual funds such as those from Rydex or ProFunds (the only thing I trade).

(I probably sound like a broken record, but…) I’ve never been a fan of seasonality plays like this. I think that there are some much more basic characteristics of the market (such as short-term mean reversion), which are much more powerful. However, these recent reports have tempered that belief just a bit. I still wouldn’t let monthly seasonality drive my trading, but I will use it as a gauge of the general sentiment of the market.

Both the options expiration week and turn of the month strategies have been added to the State of the Market report as intermediate indicators.

Comments

[Hedged In:]

Good article. I keep thinking about a comment Rob Arnott made in a Barron's interview (online.barrons.com/art...):

"If you are bearing risk, you should get paid for it. If you are picking up nickels in front of a steamroller, trying to identify opportunities to add one-tenth of a percent to your return by taking risks that could cost a 100 times that, that doesn't make sense. People need to be more disciplined about that. That includes individuals, corporations, and banks."

How many of us have trading strategies that are "picking up nickels in front of a steamroller"?

Resolution for 2009: Make sure that the risk-reward on any trade is compelling. Otherwise, don't be afraid to stay in cash.

2008 Dec 23 06:05 AM

[John Lounsbury:]

Michael - - -

Keep up the good work. While many of us may not be traders, following trading systems and being aware of technical indicators can be very helpful in trying to pick better buy and sell points for investments intended for significant holding periods. You may be trying to buy and hold for long term gains, but wise selection of buy and sell times can sometimes add significantly to the return.

2008 Dec 23 11:37 AM