Seasonality is the market’s AVERAGE performance over a given period of time. An example of seasonality is “the stock market goes up an average of 1.4% in April”. We already explained why traders and investors should be careful when using seasonality:
- Seasonality is often random.
- Short term seasonality (e.g. the market goes up X% on Thursdays) is almost completely useless.
- Seasonality can change over time. It is not constant.
- Seasonality is based on an average over a very long period of time.
Nevertheless, sometimes seasonality does give you a small statistical edge in trading and investing. That’s why some investors and traders insist on using it. So if you do decide to use seasonality for trading, here’s how to do it.
Only use seasonality when it has a very strong bullish or bearish bias
The market will always be “seasonally bullish” or “seasonally bearish”. For example, even if the market goes up an average of 0.2% in May, May is still considered a “seasonally bullish month”.
Weak seasonality tendencies like these aren’t very useful. You should only consider using seasonality when there’s a STRONG bullish or bearish bias. For example, here’s the S&P 500’s monthly seasonality.
As you can see, the stock market has a STRONG bullish tendency in January, March, April, October, November, and December. The stock market has a STRONG bearish tendency in September. It has a WEAK bullish/bearish tendency in February, May, June, July, and August.
- This means that you can take the stock market’s seasonality during STRONG months into consideration when trading (i.e. January, March, April, September, October, November, and December).
- You should ignore the market’s seasonality during WEAK months when trading (i.e. February, May, June, July, and August).
Only pay attention to seasonality when the seasonality is significantly above or below 0%.
Use small position sizes when trading with seasonality
The problem with seasonality is that you never really know if the market today will act according to its seasonality. For example, the stock market goes up an average of 1.5% in April. But that doesn’t mean the stock market will go up this April! For all we know, the stock market might go down this April. Seasonality is just an AVERAGE of the market’s performance over a given period of time. “An average” means that sometimes the market will underperform this average and sometimes the market will outperform this average.
This means that you can’t place heavy position sizes based on seasonality. You will lose a lot of money if you trade with a heavy position size and the market doesn’t act according to its seasonality this time. Each seasonality-based trade must be small, for example less than 5% of your overall portfolio.
Even seasonality tendencies that are EXTREMELY bullish or EXTREMELY bearish can be wrong. For example, perhaps “the market ALWAYS rises on the last day of each trading month”. But even when this happens, you still cannot use a big position size. You never know when a seasonality tendency with 100% success will fail. A big position size based on seasonality can lead to large losses.
Use a lot of seasonality trades
You must place A LOT of small trades based on seasonality if you’re going to use seasonality to trade. You cannot trade on ONLY one seasonality tendency alone if you use seasonality for trading. You have to trade using multiple seasonality tendencies at the same time.
For example, let’s assume that the stock market’s best month is in April (an average of 1.5% per month). You have to trade on ALL of the market’s months with a strong seasonal tendency: January, March, April, September, October, November, and December. This means:
- You can’t just place one long trade each April. Because if the market doesn’t go up this April, then your whole year will be ruined by this one instance of a seasonality failure.
- If you’re going to trade on seasonality, you have to go long in January, March, April, October, November, and December. You have to go short in September.
Use longer term seasonality tendencies and ignore short term seasonality tendencies
Sometimes two seasonality tendencies will conflict with each other. Use the seasonality whose time frame is longer and ignore the seasonality whose time frame is shorter.
For example, let’s assume that Friday is a seasonally bullish day of the trading week. Let’s assume that September is a seasonally bearish month of the year. Should you go long on a Friday in September?
No. You should either avoid going long or go short. The “market is seasonally bearish in September” is seasonality on a longer time frame. This overrides short term seasonality such as “the market has a tendency to go up on Fridays”.
Remember, seasonality should only be one of many factors that you consider when trading and investing. You should not base a trade or investment decision solely on a seasonality tendency.