An excerpt from

Trade Your Way To Financial Freedom

by Van K. Tharp
 Why Seasonals Work

The following was written by MRCI’s Editor Jerry high and low prices were used to construct relatively
Toepke for Dr. Van K. Tharp’s new book, Trade Your crude studies. Such analysis might suggest, for instance,
Way to Financial Freedom, published by McGraw-Hill. that cattle prices in April were higher than in March
We hope it helps explain the concept behind seasonal 67% of the time and higher than in May 80% of the
research and how it is derived, some of its strengths and time. Computers, however, can now derive a daily
weaknesses, and how it can be used and/or incorporated seasonal pattern of price behavior from a composite
into various styles of trading. of daily price activity over several years. Properly
constructed, such a pattern provides historical
Theanticipate
seasonal approach to markets is designed to
future price movement rather than
perspective on the market’s annual price cycle.

constantly react to an endless stream of often Annual Price Cycles

contradictory news. Although numerous factors affect Cycle Seasonal Pattern Fundamental
the markets, certain conditions and events recur at Component Characteristic Condition
annual intervals. Perhaps the most obvious is the annual
Bottom Seasonal Low Greatest Supply/
cycle of weather from warm to cold and back to warm. Least Demand
However, the calendar also marks the annual Ascent Seasonal Rally Increasing Demand/
passing of important events, such as the due date for Decreasing Supply
U.S. income taxes every April 15th. Such annual events Peak Seasonal High Greatest Demand/
create yearly cycles in supply and demand. Enormous Least Supply
supplies of grain at harvest dwindle throughout the year. Descent Seasonal Decline Decreasing Demand/
Demand for heating oil typically rises as cold weather Inreasing Supply
approaches but subsides as inventory is filled. Monetary
liquidity may decline as taxes are paid but rise as the
Federal Reserve recirculates funds. Basic Pattern Dynamics
Natural Market Rhythms Consider the following seasonal pattern that
evolved for January Heating Oil. Demand, and therefore
These annual cycles in supply and demand give prices, are typically low during July — often the hottest
rise to seasonal price phenomena — to greater or lesser month of the year. As the industry begins anticipating
degree and in more or less timely manner. An annual cooler weather, the market finds increasing demand for
pattern of changing conditions, then, may cause a more future inventory — exerting upward pressure on prices.
or less well-defined annual pattern of price responses. Finally, the rally in prices tends to climax even before
Thus, seasonality may be defined as a market’s natural the onset of the coldest weather as anticipated demand is
rhythm, an established tendency for prices to move in realized, refineries gear up to meet that demand, and the
the same direction at a similar time every year. As such, market begins to focus instead on inventory liquidation.
it becomes a valid principle subject to objective analysis
in any market.
In a market strongly influenced by annual cycles, Jan Heating Oil(NYM) 15 Year Seasonal(86-00)
seasonal price movement may become more than just an 100
effect of seasonal cause. It can become so ingrained as
to become nearly a fundamental condition in its own Inventory
Building
right — almost as if the market had a memory of its 75
own. Why? Once consumer and producers fall into a
pattern, they tend to rely on it, almost to the point of
becoming dependent on it. Vested interests then 50
maintain it.
“Pattern” implies a degree of predictability. Future
prices move when anticipating change and adjust when 25
that change is realized. When those changes are annual
in nature, a recurring cycle of anticipation/realization HOT!
evolves. This recurring phenomenon is intrinsic to 0
the seasonal approach in trading, for it is designed to Mar Apr May Jun Jul Aug Sep Oct Nov Dec
anticipate, enter, and capture recurrent trends as they
emerge and exit as they are realized. The other primary petroleum product encounters a
The first step, of course, is to find a market’s different, albeit still weather-driven, cycle of demand as
seasonal price pattern. In the past, weekly or monthly exhibited in the seasonal pattern for August Gasoline.

MAY 2000- MOORE RESEARCH CENTER, INC.

Prices tend to be lower during the poorer driving Therefore, a seasonal pattern constructed
conditions of winter. However, as the industry begins from daily prices can depict not only the four major
to anticipate the summer driving season, demand for components of seasonal price movement, but also
future inventory increases and exerts upward pressure especially reliable segments of larger seasonal trends.
on prices. By the official opening of the driving season Recognizing fundamental events that coincide with
(Memorial Day) refineries then have enough incentive these punctuations can provide even greater confidence
to meet that demand. in the pattern.
Aug Unleaded Gas(NYM) 14 Year Seasonal(86-99) Consider the seasonal price pattern that has
100 evolved for September 30-Year Treasury Bonds. The
Memorial U.S. Federal government’s fiscal year begins October 1,
Day perhaps increasing liquidity and easing borrowing
Inventory
Building 75 demands somewhat (even if only for accounting
purposes). Is it merely coincidental that the tendency
for bond prices to rise from then tends to culminate
50 with personal income tax liability for the calendar year?
Does the seasonal decline into April/May reflect a
market anticipating tighter monetary liquidity as taxes
25 are paid? Notice the final sharp decline beginning —
surprise! — April 15th, the final date for payment of
U.S. income taxes. Does liquidity tend to increase
0 sharply after June 1 because the Federal Reserve finally
Jan Feb Mar Apr May Jun Jul recirculates funds?
Take a close look at the typical market activity
Seasonal “Pegs” surrounding December 1, March 1, June 1, and
Seasonal patterns derived from daily prices rarely September 1 — dates of first delivery against Chicago
appear as perfect cycles. Even in patterns with distinct Board of Trade quarterly futures contracts on debt
seasonal highs and lows, seasonal trends in between are instruments. Finally, notice the distinct dips during the
sometimes subject to various, even conflicting forces first and second week of the second month in each
before they are fully realized. A seasonal decline may quarter — November, February, May, and August.
typically be punctuated by brief rallies. For example, Bond traders know that prices tend to decline into the
even though cattle prices have usually declined from second day of a quarterly Treasury refunding —
March/April into June/July, they have exhibited a strong at which time the market gets a better sense of the
tendency to rally in early May as retail grocery outlets three-day auction’s coverage.
inventory beef for Memorial Day barbecues. Soybean
prices tend to decline from June/July into October’s Nov Soybeans(CBOT) 15 Year Seasonal(85-99)
harvest, but by Labor Day the market has usually 100
anticipated a frost scare. U.S. Planting
FND
Conversely, a seasonal rally may typically be SH
punctuated by brief dips. For example, uptrends are 75
regularly interrupted by bouts of artificial selling Crop Being "Made"
pressure associated with First Notice Day for nearby FND
contracts. Such liquidation to avoid delivery can offer FND SK 50
opportunities to take profits and/or to enter or reestablish SF
"February FND
positions. Break" SN Harvest
25
Sep 30-Year T-Bonds(CBOT) 15 Year Seasonal(85-99)
100 FND
End of SQ Frost
U.S. Tax Year Rally 0
FND 75 Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov
FND USU
USH
Quarterly Consider the pattern for November Soybeans as it
Quarterly April 15 Treasury has evolved in the 20 years since Brazil became a major
Treasury Refunding 50 producer with a crop cycle exactly opposite that in the
Refunding
FND
FND Northern Hemisphere. Notice the tendency for prices to
USM
USZ work sideways to lower into the “February Break” as
25 U.S. producers market their recent harvest and Brazil’s
Quarterly Quarterly crop develops rapidly. By the time initial notices of
Treasury Treasury
Refunding delivery against March contracts are posted, the
Refunding
0 fundamental dynamics for a spring rally are in place —
Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep the Brazilian crop is “made” (realized), the pressure of
MAY 2000 - MOORE RESEARCH CENTER, INC.
U.S. producer selling has climaxed, the market market’s trading pattern from the 1970s. Conversely,
anticipates the return of demand as cheaper river relying solely on disinflationary patterns prevalent in
transportation becomes more available, and the market 1981-1999 could be detrimental in any new inflationary
begins focusing attention on providing both an incentive environment.
for U.S. acreage and a premium for weather risks. During such historic transitions in underlying
By mid-May, however, the amount of prime U.S. fundamentals, trading patterns will evolve. Analyzing
acreage available in the Midwest for soybeans is mostly cash markets can perhaps help neutralize such effects,
determined and planting gets underway. At the same but certain patterns specific to futures (such as those
time, Brazil begins marketing its recent harvest. The that are delivery- or expiration-driven) can get lost in
availability of these supplies and the potential of the new translation. Thus, both sample size and the sample itself
U.S. crop typically combine to exert downward pressure must be appropriate for its intended use. These may be
on market prices. The minor peaks in late June and determined arbitrarily, but best by a user fully cognizant
mid-July denote tendencies for crop scares to occur. of the consequences of that choice.
By mid-August, the new U.S. crop is “made” Related issues involve projecting into the future
(realized), and futures can sometimes establish an early with statistics, which confirm the past but do not predict
seasonal low. However, prices more often decline in and of themselves. The Super Bowl winner/stock
further into October’s harvest low — but only after market direction “phenomenon” is an example of
rallying into September, perhaps on commercial demand statistical coincidence: no cause-and-effect relationship
for the first new-crop soybeans and/or concerns over an exists. However, it does raise a valid issue. When
early crop-damaging frost. Notice also the minor computers mechanically sift only raw data, what
punctuations (declines and rallies) associated with First discoveries are truly relevant? Does the simple, isolated
Notice Day for July, August, September, and November fact that a pattern has repeated in 14 out of the last 15
contracts. years make it necessarily valid?
Inherent Strengths/Weaknesses Nevertheless ...
Such trading patterns do not repeat without fail. Certainly, patterns driven by known fundamentals
The seasonal methodology, as does any other, has it own inspire more confidence; but to know all relevant
inherent limitations. Of immediate practical concern to fundamentals in every market is impractical. Properly
traders may be issues of timing and contraseasonal price constructed seasonal patterns may typically help one
movement. Fundamentals, both daily and longer term, find trends that have recurred in the same direction
inevitably ebb and flow. For instance, some summers during the same period of time most years with a high
are hotter and dryer — and at more critical times — than degree of past reliability. Finding a “cluster” of such
others. Even trends of exceptional seasonal consistency historically reliable trends, with similar entry and/or exit
are best traded with common sense, a simple technical dates, not only reduces the odds of statistical aberration
indicator, and/or a basic familiarity with current but also implies recurring fundamental conditions that
fundamentals to enhance selectivity and timing of presumably will exist again in the future and affect the
entry/exit. market to one degree or another in a more or less timely
How large must a valid statistical sample be? manner.
Generally, more is better. For some uses, however, A seasonal pattern merely depicts the well-worn
“modern” history may be more practical. For example, path a market itself has tended to follow. It is a market’s
Brazil’s ascent as a major soybean producer in 1980 was own consistency which provides the foundation for why
a major factor in the nearly 180-degree reversal in that seasonals work.

MAY 2000 - MOORE RESEARCH CENTER, INC.