End of year strategy

December is the season of market reversals. If the market has moved in one direction in the months prior to December you can expect a u-turn in the last month of the calendar.

December 2008 was an excellent example. The euro had been falling against the dollar since July. But in early December it suffered a violent reversal, appreciating 17% in two weeks. This shift anticipated nothing in January; the united currency promptly resumed sinking in the first quarter until it bottomed in early March. The vault higher in December had nothing to do with fundamental changes in the currency or in interest rates.

The reason for the volatility is liquidity — or rather the almost complete lack thereof. The largest players in the currency markets, the banks and funds, close their books for December. Without their volume stop loss orders protecting profits often drive trading. The resulting currency rates reflect those few inputs and not the decision of the entire market. Consequently rate levels reached in December rarely stand. Witness the trading of history of the five Decembers before 2008.

In December 2007 the euro plummeted from a high of 1.4769 in the first week to a low of 1.4309 in the third. In the following three weeks it reversed up to 1.4921.

In December 2005 the euro fell from a high of 1.2058 in the first week to 1.1777 in the last week of the month. But at the start of the New Year it switched gears, rising to 1.2181 and continued higher to 1.2322 by the last week in January.

Trading in December 2004 was similar. From a low of 1.3139 early in the month the euro climbed to 1.3665 on the final day of the year. But by the end of the first week in January it had sunk to 1.3025 and continued falling to 1.2731 by the second week of February.

In December 2003 the euro rose from 1.1937 in first week to 1.2910 on the first trading day of the New Year. It then suffered a month long drop to 1.2218.

Only December 2006 does not conform to this pattern. From a high of 1.3366 during the second week of the month it dropped to 1.3090 by the final week. It then continued to fall in the New Year to a low of 1.2865 in the second week of January.

The reason for these reversals is simple. The market movement in December represented only a small fraction of the market opinion. When the mass of traders return in January they have, in five out of the past six years, expressed an opinion different than the conclusion of December.

So there are two ways to play the end of the year. If there has been a trend going into December it is a much better than even bet that there will be a profit-taking reversal sometime in the month, often in the first two weeks when major players are winding down but not yet absent. But that move does not usually last into the New Year, so you can play the reversal of the reversal in January as well.

But before you step into January ask yourself if the December move stems from a fundamental change in the currency’s outlook. This year we may have that once in a decade event for the U.S. dollar. If U.S. interest rates continue their December run into the New Year the dollar will also. But either way be prepared for some unusual volatility.

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