Traders often use fundamental or technical analysis to assess the foreign exchange market. However, there is another method for predicting price trends and that is to use seasonality - the evolution of price itself.
Seasonality analysis is arguably a method more familiar to equity traders, with terms like ‘January effect’, ‘Santa Rally’, and ‘turn-of-the-month effect’ often cited in the explanation of the price movements within equity markets. But seasonality can also be found within the forex market, as with technical analysis, statistical significance rises when large numbers of traders are harbouring the same expectations.
Trends in the forex market
Examining seasonal trends in the forex market brings forth some of the most traded currency pairs and a variety of interesting phenomenon. Some of these seasonal trends are supported by fundamental reasons.
US dollar in May?
Historical data on the USD index shows that it has mostly gained in the month of May, rising nine times out of ten in the ten years to the end of 2016. Expanding the sample size to thirty years (between 1987 and 2016), a regression test would suggest that this remains the case with an almost 90% confidence level. One fundamental explanation for the trend is the seasonal improvement in economic momentum going into each second quarter in the US, supporting a strengthening of the US dollar against other major currencies.
USD/JPY and the business cycle?
Looking at seasonality in USD/JPY often brings up March. Given the Japanese business cycle, you would expect a large repatriation of funds that month, which should boost the yen. However, Japanese yen has only risen against the US dollar in March 30% of the time over the last ten years, reminding us of the pitfalls in using seasonality assumptions alone.
A more prominent trend appears in October, where the Japanese yen weakness had been apparent 70% of the time in ten years. While it may be difficult to pin this to any single fundamental reason, an improvement in risk sentiment may in part be responsible for the flow. Seasonal uplifts for US equity markets through the third quarter earnings season, especially in the past couple of years, do make for soft demand for perceived safe havens like the yen. Once again, a regression test of the past 30-years data supports this to be true at close to 90% confidence.
Commodity currencies are sensitive to the idiosyncrasies of commodity prices. Take the Canadian dollar (CAD) and US crude as an example. February through April has traditionally been strong months for WTI crude, with the prices rising in 90% on February for the past ten years. Whether it is anticipation of the summer driving season in the US or a switchover to summer-blend fuels, this trend appears to have a clear impact upon the oil exporting country’s currency against the US dollar. One thing to note, though, is that despite the strong correlation in the past ten years, a regression test finds little significance here.
Depending on the situation at hand, the application of one or a mixture of analyses could facilitate forex traders in forming a trading idea and there are certainly no 'best' methods of analysis.
There has been a vast amount of literature and analysis given over to dispelling the significance of seasonality in the foreign exchange market. Some have also suggested that seasonal components that were significant in the past have dissipated in recent times.
Indeed, the maths of seasonality suggests that the finding is a reflection of the average and is certainly not the rule. However, should a trend be repeating itself a good 80% to 90% of the time, it may not be the wisest idea to go against it when you have the same investment horizon. Vice versa, a strong bias can also find support from seasonal trends.
One of the more popular types of seasonal investing strategies forms part of a popular stock trading strategy. There is an old saying in trading, 'sell in May and go away'. This trading wit represents the typical seasonal weakness the stock market experiences during the summer months between May and October.
According to the Financial Analyst Journal, a study which observed this phenomenon found it did exist between 1998 and 2012 with stock returns giving higher returns in the November to April period than the May to October period. This doesn't necessarily mean the summer months were overall negative, however.
However, the observation does occur in another popular seasonal stock trading strategy, which is the 'Santa Claus Rally'. This is the tendency for stock markets to rally during the last five trading days of the year and the first two of the New Year. It is important to remember that seasonal trading merely provides an extra edge to a trading strategy. A seasonal trader would also look at other indicators and tools to identify markets which offer the best clarity to trade on and never solely rely just on one measure of analysis.
Years of forex market data shows that currencies will most likely set their highs and lows for the week at the beginning and end of the trading week. Intuitively this makes sense: if a currency is in a fairly consistent uptrend, its low on Monday will likely hold through Friday and the opposite should also be true. Furthermore, major European and North American currencies will also tend to see larger price moves towards the end of the week.
Of course this is all very interesting, but the first question that immediately comes to mind should be obvious: how do we use this in our trading?
Forex Seasonality Strategy
If we wish to speculate that Monday’s Highs or Lows will hold, we are likely speculating that the currency will continue in one direction through the subsequent week of trade. There are a number of ways to do this, but sometimes the simplest solution is best when it comes to trading strategies.
Entry Rule: On Tuesday, set a Buy Stop entry order at Monday’s high, a Sell Stop entry order at Monday’s low. We will maintain these Buy and Sell Stop entry orders throughout the week unless we have already gone long or short the pair, respectively.
Stop Loss: The opposite stop entry order will take us out of a given position and set a trade in the opposite direction. This will be the case unless there was already an order triggered in the other direction through the previous week of trade. In other words, if the strategy goes long at Monday’s high but subsequently flips direction at Monday’s low, there will be no stop order in place on the ensuing short position.
Take Profit: None
Exit Rule: Close as near to Friday’s closing price as possible.
Applications for Every Day Trading
Now that we know of currencies’ tendency to make their highs and lows at the beginning and end of week, we can use this as a filter of sorts for our own trading techniques. If employing a trend-based trading system, a trader may want to see whether a currency has broken its early-week high or low and take a trade in that direction. If a trader employs a more range-based trading system, they may also watch for the currency’s ability to establish a single direction following a break of the early-week high or low.
Though nothing is perfect, this research shows that a trader likely has a better chance of success if trading with the general seasonal tendencies.
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