Traders and investors in financial markets employ a range of strategies to try and outwit and outperform markets. Technical analysis and fundamental analysis are two of the most popular methods of analysis, but there are market players who seek and study the behavior of different financial instruments at different periods of the year – these are the so-called seasonal patterns of financial markets.
What is Trading Seasonality?
Seasonal Trading is a strategy developed by Perry J. Kaufman to investigate seasonal patterns in stock prices. The approach uses the Monthly Seasonality research to examine monthly price movement and then adds simulated buy and sell orders based on the results.
According to the seasonality definition, seasonal trends are a predicted fluctuation in price. They occur at the same time every day, week, month, and year. The seasonal cycles will only tell you whether a certain currency pair is likely to bottom, top, rally, or sink at a given point in time. Seasonality is only an average. It’s best not to use it in isolation in this case. Instead, combine it with your technical analysis because the market can deviate from its Forex seasonal trend. Seasonal trading can be used to forecast future FX movements. There are seasonal patterns that repeat not only on a monthly basis, but also at every temporal level.
Trading System for Seasonality
A smart seasonality trading strategy considers the time factor from the top down. This means that the seasonal pattern is broken down from the longer time frame to intraday seasonality patterns.
Furthermore, we could look at the EUR/USD and GOLD seasonal cycles as examples.
Monthly Seasonal Patterns of the EUR/USD
Even if you are a short-term trader, it is critical to consider the general trend. Swing traders can use monthly seasonal cycles to forecast seasonal low points to buy in an uptrend and seasonal high points to sell in a downtrend.
Using only these euro patterns, we can make an educated bet as to whether EUR/USD is more likely to be stronger, weaker, or simply consolidating:
- EUR/USD often reaches a low in mid-February.
- The price then rises through mid-March, with a little reversal followed by another climb towards the end of April.
- June is another month where the EUR/USD begins to fall.
- August is one of the worst months for the euro, with the largest drop, but it is quickly recovered in September.
- Earlier September is the Euro’s second-best month. This seasonality cycle diverges and becomes less predictable after October.
An Example of Seasonality in GOLD
As an example, since 2006, gold has performed exceptionally well in January and August. The table below illustrates GLD’s (the ETF that tracks the gold price) monthly performance:
Seasonal Trading Strategies Importance & Drawbacks
Why do traders employ seasonality in their trading strategies?
Understanding seasonality is essential in trading. Why is this the case? The major reason for investigating seasonalities is that it is believed that most of the anomalies you detect in your backtests are caused by seasonalities that have been hidden. Turnaround Tuesday, for example, is primarily due to seasonality and is not an aberration. Wherever you detect correlation in trade, it could be due to hidden seasonality. Another rationale for trading using seasonalities is that they can be very valuable inputs into strategies when combined with other criteria.
Seasonality is used in research and live trading, at least in stock trading. A variety of seasonal trading tactics are used. The explanation is straightforward: it is assumed that the majority of the edges are structural and thus more likely to last year after year. The turn of the month trading approach, for example, is most likely the product of behavioral tendencies; some call this a structural trading advantage.
Drawbacks with seasonal trading strategies
One disadvantage of many seasonal trading strategies is the number of observations or the lack thereof. Noise and unpredictability lurk at every corner in the financial markets, and you may have to be careful not to draw premature conclusions. An annual pattern occurs just once a year, hence 30 years are required to collect 30 observations. This is not supported by any statistical evidence.
Having as many observations as possible is a general rule in trading. Because they desire a large sample of observations, the Medallion Fund primarily trades short-term patterns. You may want to remember this when you’re backtesting. A further disadvantage is that markets are not stationary. You may have to compensate for losses in seasonalities that stop working.
Conclusion
The seasonality trading technique is a useful one, the smart money does the same thing every year. In any market, the month of the year, the day of the week, and the time of day can all have a role. Another technique is the Time-Based Trading Strategy. Another valuable tool in your trading arsenal is the seasonal cycle. You probably should not trade only on seasonality and disregarding anything else. However, you may add this trading technique to your own trading strategy.
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