What Is The Santa Claus Rally and How Do You Trade It?
At the end of every single year, both traders and investors gear up for a unique phenomenon in the markets called the 'Santa Claus rally.'
Over the years, there have been many different interpretations of this unique event in which the S&P 500 stock market index has averaged a gain of 1.6% with positive returns more than 75% of the time since 1969.
In this article, we cover what the Santa rally is, the different causes that can contribute to this seasonal-phenomenon and how to trade it.
Table of Contents
What is the Santa Claus Rally?
What is the Santa Claus rally? The Santa rally is a term used to describe the seasonal tendency for the stock market to rally higher during the Christmas period. In the past, this tendency has also been called the Santa rally, December effect or Turn-of-Year effect.
The Christmas stock market rally also fits into the broader group of the Holiday effect. There are strong seasonal tendencies around all the major holidays for reasons that will become apparent when we look at the causes of the Santa Claus rally.
So when exactly is the Santa rally? Is it the whole of the month or just a few days of the month? To understand this phenomenon better it is important to understand the history of the Santa rally first and then look at the price chart of the stock market during this phenomenon!
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Will there be a Santa Rally This Year?
The first evidence to be produced regarding a stock market Santa Claus rally was in 1942 when S.B Wachtel presented it in the Journal of the Business of the University of Chicago. The analysis showed that there tended to be a rise in the stock market (using the Dow Jones Industrial Average index) from December to January from 1927 to 1942.
Since then, there have been many variations of the Santa rally, but the most popularised version and the one that still stands to this day is the research done by Yale Hirsch in 1972 and presented in the 1973 Stock Trader's Almanac. Hirsch discovered that the stock market rallied within the last five days of the year and the first two days in January.
The chart below shows the change in the percentage of the S&P 500 stock market index during the last five days of the year and the first two days of the new year:
When it comes to analysing the Santa rally statistics, it is clear to see that there is a tendency for the stock market to rally during this period of time. Of note was the Santa rally 2018 which performed well. While 2014 and 2015 were down years, the average of the 2008 to 2018 period is still positive.
However, it's important to note that the founder of this phenomenon, Yale Hirsch, would use this as a barometer of what could happen for the next year. The theory suggests that if the Santa Claus rally does not happen then the next year has a higher chance of being flat or negative. However, if the Santa Claus rally did happen, there is a higher chance of the next year being positive.
While this phenomenon did work in 2020 (as 2021 was a bullish year in the S&P 500 index), the bullish Santa rally in 2021 didn't help for the next year as the S&P 500 index ended lower in 2022.
When using historical data or seasonal tendencies it is also prudent to add more types of analysis when forecasting the market. For example, the Russia-Ukraine war and aggressive interest rate hikes were just two major factors why the stock market entered a bear market in 2022.
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Causes of the Santa Rally
There are a variety of different reasons why there is a seasonal tendency for the stock market to rally at year-end and over the Santa Claus rally's seven-day period. Some include:
▶️ Tax-loss harvesting is when investors sell stocks at a loss at the end of the year to offset capital gains tax. This means they are buying back their positions in the market causing weak stocks to rally higher which will naturally push up the strong stocks on momentum flows.
▶️ More people are also on holiday during this period of time which means many large institutional investors will not be at their desks. This could result in less active short sellers being present in the market, leaving long-only algorithms for mutual funds to keep buying the dips for investors' portfolios.
▶️ End-of-year bargain hunting also takes place as investors focus on what to put in their portfolios for the next year. This is why value stocks can have a tendency to outperform towards year-end as investors bank gains on growth stocks and put some back into value stocks which present a greater reward to risk over the long term.
▶️ It could also just be a self-fulfilling prophecy! Traders and investors are always looking for an edge in the market. While year-end optimism, investing of executive bonuses or any of the other reasons listed above could explain the phenomenon it could also be because the tendency was first found in 1942! As it has been around for so long, investors anticipate it and react to it, thereby keeping the phenomenon intact!
Whatever the reason, it is there and important to know about. So what are the possible trading opportunities around it? Let's take a look! ▼▼▼
Santa Claus Rally Trading Strategies
There are a variety of ways traders can take advantage of the Santa Claus rally. However, because the Santa Claus rally is over seven days, it lends itself much better towards shorter-term strategies.
For the most part, the simplest method would be to buy on the first of the last five days of the year and then close out at the close of the second day of the New Year. The problem is where do you put a stop loss and how do you risk manage the position? While history shows the period averages a positive 1.5% gain, there could be some wild swings to the downside on some occasions.
Many traders may then decide to look at the seven-day period of the Santa rally on a lower timeframe and employ day-trading type strategies to try to identify bullish price action patterns, or technical trading indicators to support buying during a period where history shows there is a tendency to have more buyers than sellers.
The chart below shows the lower timeframe four-hour chart of the S&P 500 stock market index during the Santa Claus rally period in 2019.
The highlighted yellow box on the chart above shows an example of a popular candlestick trading pattern called an Inverted Hammer. It is a pattern that is usually found after a downtrend and one which traders would take as a signal for a trend reversal.
Traders could also add technical trading indicators to look for further clues of buying. In the example above, at the time of the Inverted Hammer, the Stochastic Oscillator was below 20 which is considered oversold and where the market may push up.
In this instance, traders could simply have an entry one point above the high of the Inverted Hammer with a stop loss one point below the low. This would have resulted in a possible entry price of 3226.50 and a stop loss at 3211.15. If trading 10 lots, then this would result in a potential loss of -$153.50. If the trader targeted the next swing high point at 3251.54, this would have resulted in a profit of $250.40.
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What Happens Before and After the Santa Rally?
Some longer-term traders and investors may look at the period that leads up to the Santa Claus rally, as there is a seasonal tendency for stock markets to start rising from October. Below is a chart showing the percentage of months which closed higher than they opened over the last 20 years ending in 2020 for the S&P 500 Large Cap Index from the CBOE Options Index.
This shows that there is a strong tendency for the stock market to rally from October all the way to the end of the year. This could be due to many reasons such as traders being more active in the market to end the last quarter of the year well, more optimism around the holiday period creating more revenue for different companies, etc. Whatever the reasons, the pattern is evident.
In this instance, traders may take a longer-term approach and start to build positions in stock markets from October to the end of the year. This could involve looking at the daily timeframe charts and utilising more of a swing trading style. As the market tends to rally during the end of the year and into the Santa rally dates, both traders and investors may start to build positions in anticipation of higher prices.
The S&P 500 index seasonal chart above also shows that the January period leans more towards the bearish side by the end of the month. This is important to know from a trade management perspective as you don't want to hold your positions over a weaker period of time. Traders may use trailing stop losses to help maximise gains and minimise losses on a potential move lower.
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How to Trade the Santa Rally in 4 Steps!
Once you have a potential trading setup, you can place a trade in just four steps, as shown below:
- Open your MetaTrader 5 trading platform provided by Admirals, or start your free download here.
- In the Market Watch window (Ctrl+M), type in the instrument you want to trade and select it from the pre-populated list.
- Drag the symbol onto the chart and open a trading ticket by pressing F9, or using the right-click options.
- Fill in your stop-loss and take-profit levels, and volume amount, then either press Buy if you believe the market will rise or press Sell if you believe the market will fall. Done!
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FAQs on the Santa Rally
What is Santa Claus Rally?
The Santa Claus rally is a stock market theory which suggests that there is a tendency for stock markets to rise during the last week of December and the first two trading days of the new year.
What causes a Santa Claus rally?
There are a variety of factors that could contribute to the Santa rally. This includes tax loss harvesting, year-end profit taking and sector rotational strategies.
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or recommendation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.