The January Effect: Put the Calendar on Your Side

2008 has been a year that investors would like to forget, and for most, profits will have to wait until 2009. Why? Well, the answer can be found in what is called the "January Effect."

The January Effect is best described as the rally-inspired increase in stock prices during the month of January following a drop in prices from December tax-loss sell-offs.

In 2009, I anticipate a bigger January effect than we've seen in many years.

Savvy investors itching to ameliorate the horrible results brought on by the precarious events of 2008 would be well advised to put the calendar on their side, and to position some of their assets in anticipation of the January Effect.

But where might the upside caused by the January effect be felt the most?

Historically, it's been the small-cap sector of the market. This January, however, I suspect that it won't be just small-cap stocks that get a lift from the January effect.

With a market battered into submission on the order of more than 40% in 2008, there will likely be plenty of tax-loss selling in just about every market segment - including small-cap, mid-cap and large-cap stocks.

An Imperfect Precedent

Since the January Effect occurs largely because investors choose to sell some of their shares right before the end of the year in order to claim a capital loss for tax purposes, when the tax calendar rolls over to a new year the buying usually resumes.

Now because the shares of smaller stocks - the most illiquid of equities - typically take a bigger beating in a market downtrend than their big-cap brethren, it stands to reason that small-cap stocks would be the first to come roaring back after the tax-loss selling takes place.

If we look at the historical data of January 2000 to the present, we find a mixed bag of performance for the month. During this timeframe, the average monthly percentage gain for the Dow Jones Industrial average was a decline of 1.42%. For the broader S&P 500 Index, the decline came in at 0.99%.

In contrast with these declines, however, we have the small-cap Russell 2000 Index, which gained 0.35% on average.

Now I grant you that at least in the 21st century, the January Effect has been minimal not the kind of average performance one would get overtly excited about.

But despite the small bump in small caps during the past eight years, this year has all of the makings of a big bump.

If you consider external factors, such as a widely oversold market; the Federal Reserve's commitment to "employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability" and the swearing in of President-elect Obama and his new economic team, you have the recipe for a January Effect that could be very substantive.

Getting in the Game

If the January Effect does kick into high gear in 2009, there are several ways traders can take advantage of it. The following are not recommendations. They are just to give you an idea of the thought process that anyone can use at the beginning of each year.

The first is to look at an exchange-traded fund (ETF) that mirrors the price performance of the leading small-cap index - the iShares Russell 2000 Index (IWM | Quote | Chart | News | PowerRating).

As you can see in the chart below of IWM, it appears poised for a breakout, having recently breached is short-term, 50-day moving average (blue line).

By owning IWM, you can put the potential move higher in small caps due to the January Effect on your side.

For the more intrepid traders out there, you can use the two-beta, leveraged ETF pegged to the Russell 2000, the Ultra Russell 2000 ProShares (UWM | Quote | Chart | News | PowerRating). With UWM you get twice the daily performance of the Russell 2000 Index. So, if the Russell 2000 climbs 2%, then UWM will jump 4%.

Finally, for those who prefer to trade options, you can look into a long call option strategy that will help you participate in the upside of the index without as much downside risk. In a long call strategy, your maximum loss is limited to the premium paid for the options.

Theoretically, at least, there is no limit to how high the Russell 2000 can climb, and that gives your long call strategy virtually unlimited profit potential - minus the original premium you paid for the right to own the underlying index. In this case, you would be buying calls on IWM.

Only time will reveal the answer to the question of whether the January Effect will come to fruition in 2009. But now you know how to take advantage of it if it does.

Jim Woods is a Senior Editor for optionszone.com. To Read more of his articles Go to http://www.optionszone.com/learn-more/michael-shulman/gallery/10-reasons-to-use-etfs.html