While the January effect might sound like a winter weather advisory term coined by the Weather Channel, it’s actually a documented stock market phenomenon.
In the trading world, the so-called January effect is a seasonal stock market phenomenon that affects the prices of various securities. This post will introduce you to the January Effect, including what it is, how it works, and how it can give you an edge in trading.
Table of Contents
- 1 What is the January Effect?
- 2 How to Take Advantage of the Stock Market January Effect in 5 Steps
- 3 The Bottom Line
What is the January Effect?
To understand the January effect, you actually have to rewind the calendar back to December.
Traditionally, the month of December is punctuated with plenty of price drops in the market due to various factors including buyers selling off positions in hopes of balancing out their capital gains.
Then, during January, there’s traditionally a turnaround as stock prices increase.
Studies have shown that the average return during January is significantly higher than other times of the year. This trend is particularly prominent with small-cap stocks.
Key Points to Explain the January Effect
Why does this price drop then increase regularly happen between December and January?
Here’s an efficient market hypothesis of the January effect …
Tax Loss Selling
The most common explanation for The January effect is that it’s the result of tax loss selling.
Traders or individual investors frequently dump stocks at the end of the year so that they can claim capital losses. Then, they can then reinvest after the new year.
This massive sell-off drives prices down, which can attract other buyers who are interested in buying in during these traditionally low priced times. This slowly builds, driving prices back up in January.
However, some analysts say that the January effect is less prevalent in this day and age because more and more people are relying on tax-sheltered retirement plans, which give them less of a reason to rush to sell before the end of the calendar year.
Flamboyant Christmas displays come down in January, but window dressing has a different meaning In the context of the January effect.
One theory behind the seasonal effect is that it’s partly due to mutual fund managers buying up top-performing stocks and unloading the dead weight or underperformers toward the end of the year.
This phenomenon is referred to as “window dressing.” However, while this may contribute to the overall mood in the market, window dressing more prevalent within the large-cap stock world, and the January effect is more famously associated with small-cap stocks.
Trading Benefits of the January Effect
Does the January effect make January one of the best months for stocks? Let’s explore some of the benefits of the January effect:
- Predictable seasonal fluctuation. Since the January effect typically spans December and January, traders can account for certain price variations and may be able to take advantage of this effect to determine entry and exit points.
- Make the most of losses. By taking losses before the end of the year, they can be declared as a loss on your next tax return.
- Money to reinvest. By selling off shares, you might not be generating a profit and may even be experiencing losses. However, on the positive side, you now have the money from the sales to reinvest in hopefully more successful trades.
Take advantage of year-end bonuses. Many individuals receive year-end bonuses as a perk on the job. This means that they can take advantage of their new funds in January.
How to Take Advantage of the Stock Market January Effect in 5 Steps
Want to take advantage of the traditionally strong January stock market performance? Follow these five simple steps.
#1 Select Small-Cap Stocks
Interestingly, and serendipitously for traders with small accounts, the January effect is most pronounced with small-cap stocks, likely because they’re less liquid.
Believe it or not, this is a trend that has some significant history backing it.
As early as 1942, investment banker Sidney Wachtel reported in his article, Certain Observations on Seasonal Movements in Stock Prices, that small-cap stocks have traditionally outperformed the market during January, particularly in the middle of the month.
The effect may vary from year to year and has lessened in recent years, but still does exist.
#2 Choose Between Short or Long Positions
To make the most of the January effect, choose between short or long positions from the get-go. There can be opportunities in either direction depending on your timing (December versus January) and depending on whether you focus on small or large cap stocks.
Don’t reinvent the wheel here. If you typically focus on short positions, then stick with that when trying to find opportunities that will take advantage of the January effect.
#3 Establish a Strategy to Reduce Risk
To take advantage of the January effect, you need to have a strong strategy and setup. Ideally, you can hone a setup so that you can take advantage of it over and over. However, to do that, you really need to narrow your focus.
By starting and maintaining a trading journal, you’ll be best able to keep track of what strategies and setups work best for you.
With this information, you’ll find it easier to formulate strong trading plans and to stick with them. In the big picture, this can help you reduce risk.
#4 Define When to Buy and Sell
Your trade is only as good as its entry and exit points. Both are equally important.
Your entry point is the price at which you decide to buy the stock in question.
You should perform careful research before executing a trade, looking at the stock’s past performance over recent days, weeks, months and years and backing it up with fundamental research.
Your exit point is just as important. Ideally, your exit point culminates in a big fat profit, and you feel very happy getting out of your position.
However, you should also be prepared for when to cut losses if the trade doesn’t go your way. It’s not a happy thing to consider, but do it before executing the trade and stick with the plan. Holding and hoping is not a strategy.
#5 Use a Stock Screener to Find the Best Opportunities
To find the best potential stocks to trade, and to formulate strong trading plans, take advantage of the many tools on StocksToTrade, including…
StocksToTrade was designed by traders for traders, so you can bet your bottom dollar that we’ve got charting tools, unlike any other platform.
You have your choice between candlestick, line, and bar charts, and can alter easily the time frame ranging from minutes to months.
By analyzing different time frames, you’re empowered to make the most educated decisions about appropriate entry and exit points in your trade. Charts also help you identify trends in price action.
What might be affecting the price action of a stock? StocksToTrade allows you to find out easily. The platform features links to relevant news for tickers, pulled from the headlines and social media.
Why social media? Well, social media news can hit before it gets to traditional news channels, so it’s well worth exploring the buzz. But beware that some of it isn’t from reputable sources, so always do some fact checking!
The platform has indicators a-plenty, from basic to premium. You can customize the colors of them too so that you can easily monitor different indicators on a chart.
Get a leg up on the January effect by joining StocksToTrade today! From December 21 through January 4, we’re offering up an incredible sale for the holidays:
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The Bottom Line
The January effect is a seasonal stock market phenomenon that traders can potentially use to their advantage when formulating trading plans during the end of one year and the beginning of the next.
However, it’s important to remember that the January effect offers no guarantees with trading choices: Strong technical and fundamental research is always necessary before executing any order.
Have you used the January effect for yourself? If so, leave a comment and tell us about your experience!