Don’t Fall for this Trading Trap (Do This Instead)

Nothing beats a good headline…

It draws you in with a glimpse of what’s to come.

A headline writer has several strategies in their playbook. For instance, they could shock you with a bold statement. Another approach is to intrigue you with a puzzling question.

But one of the all-time favourites is the emotional headline. The aim is to quickly hook you on a personal level. This increases the odds you’ll want to know more.

Here’s a prime example…

Sell in May as hopes of 6000 points fade away

The Australian, 4 May 2017

Which emotion would you say is in the crosshairs?

If you’re thinking ‘fear’, you’ve got it in one. The prospect of losing money is a sure-fire attention-grabber. You’ll often see this style in the financial pages. It can be hard to ignore.

Here’s a short extract from the story…

On Monday traders thought better-than-expected reports from the banks might push the index above 6000 for the first time in a decade. But the conversation yesterday shifted from whether the market would break 6000 to how big the usual “sell in May and go away” phenomenon would be.

Do you see the connection to the headline?

It’s a clever twist on an old saying: ‘Sell in May and go away’.

So, does this month’s correction signal the start of something big?

I wouldn’t bet on it.

I’ll talk more about this in a moment. There are some interesting graphs I want you to see. You’ll be able to make your own judgement on selling in May.

But first, a bit of history…

Bygone times

‘Sell in May and go away’ is part of market folklore.

The adage has been around for over a century. It dates back to England in a different era…a time when the leading players in the market were the aristocracy.

Back then, the summer social season had a big influence. The moneymen would close shop in May and head to the country. Horseracing and lawn parties put the market on a backseat.

The absence of the big hitters would see trading activity slow. Rather than risk an illiquid market, traders would sell-up and come back at the end of the season.

There are other variations of the story. For instance, the Americans link it to Halloween.

But the message remains the same: Avoid stocks between May and October.

OK, so that’s the legend. But what are the facts?

Well, it’s interesting.

Let’s split the year into two halves — 1 November to 30 April, and 1 May to 31 October.

Which period do you think has been better for investors?

It turns out November to April wins hands down. Between 1936 and 2007, the All Ordinaries average gain for this period is 5.1%. The average for the second half is 2.4%.

And there’s more…

A 2002 academic study took this further. Researchers (Bouman and Jacobsen) crunched the numbers on 37 stock markets. They found that November to April was stronger in 36 countries.

So, ‘sell in May’ has more to it than your typical folktale.

But I won’t be in a hurry to start selling.

You see, the problem with seasonal factors is they don’t appear every year. Stocks could underperform one year, but roar higher the next.

And that’s not all.

Take another look at the returns. The May to October period is still positive. Rather than avoiding trouble, selling in May could be sidestepping profitable opportunities.

Legend testing

One of the best things about algorithmic trading is back-testing. This is where you use historic data to trial a strategy. It lets you see how a system may perform in real life.

The headline in The Australian made me wonder: What if Quant Trader sold-up each year in late April? It could then buy back at the start of November, thereby missing the weaker months.

Rather than guess, I put together a simulation to test the idea.

Here’s what I did…

I added a rule that exits all trades in the last week of April. The system then stays out of the market until 1 November. This means it only trades the seasonally strong half of the year.

Another twist to the regular system is there’s no 100-company cap. The system also only trades signal 1s. These changes remove any bias that could come from stock selection.

Have a look at what happens…

Click to enlarge

The back-test runs between 1 November 1999 and 31 December 2016. It places $1,000 on every trade. And, as always, there is no allowance for costs and dividends.

Not surprisingly, the strategy makes money. But it isn’t immune to volatility.

People often say October is a risky time to trade shares. They point out this is the month of the worst market crashes. It’s often a nervous time for many traders.

But this test shows volatility can strike anytime — even in the seasonally strong months.

Here are some stats from the test…

These are solid results. You could make good money trading such a system.

Now, let me turn this on its head…

You’ve just seen the results for following the saying ‘sell in May and go away’.

But suppose we flip the strategy?

What if we buy in May and exit the portfolio in late October?

Take a moment to think this over…

Buying in May gets you in NOW — during supposedly the worst part of the year. You’d also completely miss the seasonally strong November to April period.

What do you think will happen?

OK, check this out…

Click to enlarge

Is this what you were expecting?

Probably not. This isn’t the disastrous result the folktale would have you believe. If anything, this graph shows less volatility than the previous one.

Here are the stats…

There’s little difference between the overall results. The average win is practically the same. But ‘buy in May’ produces a slightly better win rate and lower average loss.

I have one more graph for you. This is how the strategies look side-by-side…

Click to enlarge

While the lead chops and changes, the ‘buy in May’ strategy (red line) comes out ahead.

So, what’s the upshot from all this?

Take sayings like ‘sell in May and go away’ with a grain of salt.

Yes, they sound catchy. And they make for good headlines. But they often don’t stack up when put to the test.

Quant Trader is a trend-following system. It doesn’t worry about the time of year, or what the newspapers are saying. All that matters is the share price.

The underlying strategy is simple: Buy when the trend is rising, and sell when it falls.

If you can do that, you’ll never need to trade according to the calendar again.

Until next week,

Jason McIntosh,
Editor, Quant Trader

Editor’s note: Don’t let the recent volatility spook you. Jason believes stocks will shift dramatic higher during the second half of the year. He bases this on three little known indicators. You now have a rare window to step inside…and set in place a series of trades to ‘front-run’ a potentially monumental surge in ASX stocks. I’m talking about the kind of surge that — if you have the right trades in place — could turn a $12.5k starting account into over $250,000…Click here to read about this unusual opportunity.

All charts are sourced by Quant Trader unless otherwise stated.

Money Morning is Australia’s most outspoken financial news service. Your Money Morning editorial team are not afraid to tell it like it is. From calling out politicians to taking on the housing industry, our aim is to cut through the hype and BS to help you make sense of the stories that make a difference to your wealth. Whether you agree with us or not, you’ll find our common-sense, thought provoking arguments well worth a read.

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