EQD Research

Nasdaq-100 Saves The Best For Last Each Year

Oct 30, 2021

This independent content is made possible by Nasdaq

By Russell Rhoads,
head of research

Once you have been around the financial markets as long as I have you start to hear some of the same sort of statements out of the financial press depending on the time of year. We are quickly approaching the time where we will hear the phrase “Santa Claus Rally”. It turns out the reason we have these sayings is that they are rooted in some sort of historical accuracy. The chart below is a good depiction of why there is a belief in an annual year-end rally or at least bullish feelings about stocks as the New Year approaches.

 

Data Source: Nasdaq

The Nasdaq-100 win percentage is highest each year in the November to December timeframe. Over the past 32 years, going back to 1989, NDX has risen 71.88% of the time in November and 81.25% in December. Collectively, 75% of November to December observations have resulted in a gain over the final two months of the year.

So, how to trade the end of the year rally that spans the end of each year? The first idea is basic, but makes sense if you think there is a 75% chance of the market trading up from currently levels over the next couple of months. Currently, NDX options expiring on December 23. On Friday October 29, with NDX at 15850, the NDX Dec 23rd 15850 Put could be sold for 431.00 and the NDX Dec 23rd 15825 purchased at 422.00 with a net result a 9.00 credit. The payoff for this spread at expiration appears below.

The maximum profit in this case is a gain of 9.00 points while the maximum loss is a loss of 16.00. For the trade to realize the 9.00 profit NDX would need to be at current levels or higher at expiration. Admittedly, there is the potential for a gain or loss that is not equal to the maximum figures, but it is useful to consider this trade, if held to expiration, as a binary event. Approaching a vertical spread as a binary event means we can compare the best and worst case scenario to the odds of a trade working out.

If history holds, there is a 75% chance that this trade will work out with NDX higher in late December. This means based on history three out of four times this trade would make a profit of 9.00 points and one losing trade of 16.00 points. Again, the math is overly simplified, but this is a good example of comparing what the option market is pricing in versus an outlook. If this exact scenario is played out in four consecutive trades and the 75% win result holds up the results would be 27.00 points in profits and a 16.00 point loss netting a gain of 9.00 points from the cumulative four trades.

If the market prices this spread based on a 75% chance of realizing a profit the trade would generate a credit of 6.25 and have a risk of 18.75. Using this risk / reward the trade would realize 18.75 in gains for three winning trades (6.25 x 3) and a single loss of 18.75, breaking even if the 75% win rate holds up going forward.

This is an oversimplified example of taking a market outlook and comparing it to what the option market is pricing. If a trader believes there is a 75% chance of an outcome for an underlying market, the risk / reward should vary enough relative to the trader’s outlook. What the option market is currently pricing for NDX versus history represents a great example of this.