Daily Brief - What happens to markets after a -5% month?

On Feb 1st we published a piece on the so-called January effect.

There are in fact two distinct studies about January seasonality that have mystified and intrigued investors for decades:

• does January go up in general?
• does January’s performance tell us something about the rest of the year?

Clearly we’ll talk about the latter today, since we’re already in February.

We looked at the performance of the next 2 months after a -5% day (precisely, after a -4% to -7% month).

To gauge this properly, at the bare minimum you need to compare this distribution with the distribution of all other SPX months.

This comparative analysis shows that a) we’re less likely to have an all-out crash, but b) we’re more likely to have a 10% move…in either direction!

So what’s the trade?

This strikes us as profoundly interesting, since we’re all traders here.

The next question comes naturally: so what’s the price of a straddle for the next two months?

The answer is 5% to 6% for the March 31st straddle, depending on the day. Or you can spend 2.2% for a 5%-wide strangle.

With over 50% historical chances of a move larger than 5%, that sounds like an interesting risk-return profile.

The technical corner

Remember that the cheapest straddle in equity markets is always slightly above the at-the-money (because of the skew of course).

If you choose to use that out-of-the-money straddle, that will eat a bit into your returns in case of a rally BUT it will provide better profits on the downside.

The choice is of course one based on both your overall portfolio and on your views on the market.