The champagne corks have been popped, friends have toasted to good health and resolutions for the New Year have been made. The streets have been swept clean of confetti just as many portfolios have been swept clean of stocks that yielded year-end losses.
Yes, it’s that time again, when many investors will sell off stocks for tax losses to counter capital gains, then reinvest for the New Year. Every year this January strategy contributes to an increase in stock value, creating the market anomaly known as the January Effect.
The coining of the term January Effect is attributed to Donald Kiem. As a graduate student at the University of Chicago in the early 1980’s, Kiem discovered that stocks tended to increase in value during the first week of January. His study covered stock performance from 1963 to 1979. Recent market analysts have noted that this trend now appears to start near the end of December and carry over into the first few weeks of January. It has also been noted that the January Effect is more common among small cap stocks than larger cap stocks (over $10 Bil Market Cap.).
We can verify this trend by comparing some of the index charts over the past 5 years:
For example, the S&P 500 index (SPX) has shown the following increase in values:
- Dec. 9th 2004 through Jan. 15th 2005: Maximum increase – 3.8%*
- Dec. 9th 2003 through Jan. 15th 2004: Maximum increase – 7.3%*
- Dec. 15th 2002 through Jan. 15th 2003: Maximum increase – 7.4%*
- Dec. 15th 2001 through Jan. 15th 2002: Maximum increase – 5.6%*
- Dec. 15th 2000 through Jan. 15th 2001: Maximum increase – 7.3%*
(SPX had an appx. return of 9.7% from Dec. 21st 2000 through Jan. 31st 2001*)
In Comparison, the S&P SmallCap 600 Index ($SML) showed these numbers:
- Dec. 15th 2004 through Jan. 15th 2005: Maximum increase – 5.1%*
- Dec. 15th 2003 through Jan. 15th 2004: Maximum increase – 11.7%*
- Dec. 15th 2002 through Jan. 15th 2003: Maximum increase – 4.6%*
- Dec. 15th 2001 through Jan. 15th 2002: Maximum increase – 8.1%*
- Dec. 15th 2000 through Jan. 15th 2001: Maximum increase – 17.6%*
[* The above-calculated returns do not reflect the direct increase in index value from the low on Dec 9th to the high on Jan. 17th. The above returns reflect the lowest price of the index over that time span compared to the highest price of the index. Both indexes were in an uptrend over the listed time frames].
Even though the SPX shows strong returns during the 30 day periods from Dec. 15th through Jan. 15th, we can see that the Small Cap index returns have outperformed the SPX returns (with the exception of 2002-2003). In comparison, the DOW (which represents Larger Cap stocks) does not reflect this same type of growth potential year by year.
What does this mean to you?
Although December and January seem to be good months for stock growth, the January Effect is a market anomaly, not a constant that is etched in stone. Not every small – mid cap stock will increase in value but, with some research and analysis, an investor may be able to take advantage of these January Effect stocks.
Here are some tips that can help you identify January Effect stocks:
- It has been fairly well documented that this trend seems to affect smaller cap stocks more than mid-to-large cap stocks. An investor would want to search for stocks with a Market Capitalization between $200 Million to $2 Billion.
- Identify the strong Small-Cap stocks. Search for stocks currently trading above their 20-day or 50-day moving average, stocks that have a good %EPSG or Earnings per Share ratio, stocks that have a ‘Buy’ or ‘Strong Buy’ Broker Recommendation, and stocks that have a strong average daily volume.
- January Effect investors may attempt to bottom feed, looking for Small Cap stocks that are in decline or near their 52 week low after the December sell-off. These types of stocks can yield a high profit but if the fundamentals are too weak the investor may end up holding a stagnant or losing position.
Since there is no guarantee that all Small Cap stocks will rise in January, simply buying and holding potential January Effect Stocks could become costly and offer the investor little or no protection against a decline…
Question: How can an investor take advantage of this January Effect trend and, at the same time, minimize potential risks?
Answer: An investor could trade Bullish Option Strategies on potential January Effect stocks. This would allow the investor to take advantage of stock price gains without being in a position that does not offer a measure of protection.
Here are some examples:
Covered Calls. Buy shares of a researched January Effect stock and sell a corresponding number of calls against those shares. Whether you sell a call In-the-Money (set the strike below the stock price), At-the-Money (near the stock price) or Out-of-the-Money (above the stock price) you will collect a premium now that protects against a slight drop in the stock price and increases your return.
Naked Puts. Sell an Out-of-the-Money put (strike below the stock price, opposite of the call). An investor will collect a premium for selling the put and will keep the entire premium as the stock rises, causing the put to expire worthless.
Calendar Call spreads. Buy an In-the-Money LEAP (January ’07 or January ’08) call and sell near term At or Out-of-the-Money calls. This strategy is a leveraged position as the LEAP cost is a fraction of the stock price but the LEAP purchase allows the investor to mimic stock ownership.
Vertical (Credit and Debit) spreads. Combine the sale and purchase of two different strike calls (Bull Call Debit) or the sale and purchase of two different strike puts (Bull Put Credit) to take advantage of the stock movement without owning the shares of the underlying stock.
For more information on the specifics of these strategies that can help you take advantage of the January Effect, please visit PowerOptions. Also look for a future article, “The Three Horsemen of Income” for information on Covered Calls, Naked Puts, and Calendar LEAPs.