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Simon Thompson's trading secrets revealed

And the trend for prices to rise around St Patrick's Day still seems to be working: the S&P 500 rose by 1.7 per cent over the four-day trading period in March 2008, which is even more impressive considering this took place during a savage bear market. Moreover, this wasn't a one-off event, either, with the index posting gains of 0.6 per cent in 2006, 1.6 per cent during 2007 and a hefty 5.8 per cent last year during this four-day trading period.

Reasons for this phenomenon

Part of these healthy gains could result from the fact that March is a good time of the year to be invested in equities. However, the average return on the four trading days around St Patrick's Day accounts for virtually all of the 1 per cent return the S&P 500 index has averaged over the month of March in the past six decades. That's astonishing, so perhaps there is another factor at play here?

Another reason for the market to rise in this four-day trading period is due to the crossover with 'triple witching week', when stock options, index options and index futures all expire on Wall Street. This can give the S&P 500 a boost as traders settling these options and index contracts may be forced to buy into the market to close their positions out. At least, the market has risen far more often than it has fallen during triple witching week in March over the past two decades. And as triple witching day in the first quarter falls on the third Friday of March (Friday 19 March this year) there is more often than not some crossover with St Patrick's Day.

Trading Strategy: St Patrick's Day

The standout trading strategy is to buy an S&P 500 index tracker two days before St Patrick's Day and look to take profits at the close of trading the day after the festival to try to capture the near-1 per cent average rise in the index over this four-day trading period. Exchange-traded funds (ETFs) listed on the London Stock Exchange that track the performance of the S&P 500 index include Barclays iShares (TIDM: IUSA).

Alternatively, the index can be bought through a spread bet and, since you are betting in sterling for every point movement in the S&P 500, there is no currency risk, either. Structured product providers Société Générale (http://uk.warrants.com) and Royal Bank of Scotland (http://ukmarkets.rbs.com) also offer a range of covered warrants, quantos and listed-turbos on the S&P 500.

St Patrick's Day falls on Wednesday this year, so the strategy is to buy the index at the close of trading on Friday 12 March and close the position out on Thursday 18 March.

Playing Footsie

If you have banked gains on the S&P 500 trade then you could very well be tempted to invest some of these in another trade on Monday 22 March. This is the date when changes to the constituents of the FTSE 100 index become effective following the FTSE International's Quarterly Index Review. The findings of that meeting are well worth noting because as bull market trading strategies go, this one takes some beating.

All you have to do is buy shares in the companies that are being relegated from the FTSE 100 on the day they drop out of the index following the Quarterly Index Review. Hold the shares for three months and then sell up. Then start the process all over again by reinvesting the proceeds into the laggards that are being booted out of the blue-chip index following the next review.

It may be a simple trade, but it's also one that has reaped hefty gains. In fact, if you had followed this strategy from the beginning of the last equity bull market in March 2003 until the market peaked out in June 2007, you would have made an average quarterly gain of 13.6 per cent on each of the 27 companies that dropped out of the FTSE 100 following the Quarterly Index Review. By comparison, the FTSE 100 only managed to rise by 5.3 per cent on average in these 13 quarters. Moreover, the risk/reward ratio is very favourable – over three-quarters of the 27 companies posted a positive return in the three months following their exit from the index, and four of the six losing trades fell by less than 3 per cent.

And since the stock market bottomed out a year ago, this strategy has worked brilliantly - with the laggards booted out of the index in March last year rising by 35.6 per cent in the following three months and the companies exiting the FTSE 100 in mid-June subsequently rising in value by 19 per cent. And although the three laggards - Balfour Beatty, Pennon and F&C Investment Trust – that were shown the door in September turned in a 0.7 per cent average gain over the next three months, this was only slightly less than the 1.2 per cent rise in the FTSE 100 during this time. So even when the laggards only deliver modest returns they are doing no worse than holding the index. Normal business resumed when Rentokil Initial was the sole company to lose its place in the December Review, with its shares rising 20 per cent since then.

Why does it work?

There are several factors that cause shares in the FTSE 100 laggards to bounce back after their expulsion from the index. The most obvious is that a period of technical selling pressure in the run-up to their expulsion depresses valuations below fair value.

Primarily this is due to FTSE 100 index-tracking funds, whose mandates dictate that they are only allowed to hold shares in FTSE 100 constituents, being obliged to sell their shareholdings in companies ejected from the index.

Second, the Quarterly Index Review is held on the second Wednesday of March (10 March this year), June, September and December with changes to the index implemented seven trading days later. The delay between the announcement of a company’s ejection from the index and the date the changes are implemented enables traders to profit from this technical selling pressure by fund managers. For example, some investors will short-sell these shares around the time of this seven-day window with the aim of turning a profit by buying them back at a lower price at a later date, which acerbates the price falls.

Third, the fact that a company is being ejected from the FTSE 100 is due to a relatively poor share price performance in the previous three months. This creates an additional negative momentum effect, whereby some traders will pair trade these underperformers against the FTSE 100 to take advantage of their relative negative momentum, safe in the knowledge that if they are ejected from the index there will be forced selling by tracker funds to drive prices down even lower.

Academic studies

Academic studies also validate this strategy. In a paper 'Playing Footsie with the FTSE 100' published in 2006, professor Jay Dahya of City University of New York considered changes to the index over the period 1984 to 2003. Mr Dahya noted: "Deletions to the index are associated with a negative price response, which is fully reversed over a 120-day period after news of the removal from the index." He added: "The rebound in stock prices following exclusion from the FTSE 100 is also positively related with analysts' earnings upgrades (a feature of bull markets) and negatively related with a change in press coverage."

While in a paper 'The Impact of Changes to The FTSE 100 Index', The Financial Review, August 2007, Brian Mase of Brunel University found that: "Return reversal around index additions and deletions suggests that buying (selling) pressure moves prices temporarily away from equilibrium." It is this excessive selling pressure that drives down share prices below fair value and creates the conditions for a bounce back in the shares once the laggards are ejected.

It's worth noting that this is a bull market phenomenon. In bear markets, other factors, such as earnings disappointment, dampen the enthusiasm of investors looking for a rebound in the share prices of the FTSE 100 dropouts. Moreover, bear markets are associated with periods of negative investor sentiment and greater risk aversion, and any earnings disappointment in bear markets is likely to be severely punished.

Trading Strategy: FTSE 100 Quarterly Review

The FTSE International Committee next meets on Wednesday 10 March when they nominate the companies to be rejected from the index on Monday 22 March following the Quarterly Index Review. Buying the rejects from the FTSE 100 on Monday 22 March and holding them for three months while simultaneously short selling the FTSE 100 index is the advised long-short pair trading strategy. This way, if the stock market rises we would expect the laggards to outperform the index to give us a profit. Alternatively, if the stock market were to fall, and so depressing the returns on our laggards, we have a natural hedge in place to protect our capital.

Daylight robbery

It's that time of year again when the clocks go forward one hour and we are deprived of one hour's much-needed rest in bed. That may not mean anything to most people, but it is highly significant to me because I have devised a trading strategy to profit from changes in the stock markets around the time of daylight changes in the spring and autumn.

I know it may seem far-fetched, but it is possible to make money from stock markets around the time of daylight changes. The reason for this is simple: we react to changes in our body clocks, or as the medical profession likes to call it: desynchronise. For example, as anyone who has suffered a bad night's sleep knows all too well, our behaviour the next day can be dogged by weariness, lethargy and in some cases despondency. The lack of one hour's sleep when the clocks go forward one hour in the spring is hardly a major sleep imbalance. However, academics have shown that even minor sleep imbalances can cause errors in judgement, anxiety, impatience and loss of attention.

Insurance companies and car drivers know this to their cost: research confirms that there is a significant increase in car accidents following both daylight saving clock shifts in the spring and when clocks go back in the autumn. So, if changes in our sleep patterns can affect us in our everyday lives, it is logical that they could affect our behaviour when it comes to making financial decisions. In a paper 'Losing Sleep in The Market: The Daylight Saving Anomaly’, academics Mark Kamstra, Lisa Kramer and Maurice Levi (source: American Financial Review, September 2000) found that stock market returns on the first business day of the week following daylight saving weekends in the spring produced larger falls in the market than other weekends in the year.

In fact, taking data over a 30-year period from 1967 to 1998, the academics found that the mean negative return on the first trading day following spring daylight saving weekends is between two to five times greater than that following an ordinary weekend. This is not just a local phenomenon, either, as the sample included the Nasdaq Composite, S&P 500 and New York Stock Exchange Composite, Tokyo Stock Exchange 300, Dax 30 and FTSE All-Share.

This trend seems to be holding up in recent years, with the UK stock market falling nine times in the past 13 years on the Monday after clocks go forward one hour in March. And, true to form, the FTSE 100 took a pounding last year when it fell 3.5 per cent on Monday 30 March. Even in 2008, when the FTSE 100 rose by 10 points on Monday 31 March, the index was still down 100 points at the open, giving nimble traders who sold short the market at the close the previous Friday the opportunity to bank a healthy gain.

Trading Strategy: Daylight changes

The clocks go forward one hour on Sunday 28 March this year, so the recommended trade is to short sell the FTSE 100 using either an exchange-traded fund (ETF), spread bet, covered put warrants, quantos or listed-turbos at the close of play on Friday 26 March, and look to bank a profit during trading on Monday 29 March. Since 1981 the UK stock market has fallen 18 times on the last Monday of March, with an average decline of 0.93 per cent, and has only risen 11 times, with no fewer than seven of those rises being less than 1 per cent.

Budgeting for profit

The chancellor has his moment of glory in the House of Commons twice a year. First, in the autumn the government's spending and tax raising plans are unveiled in the pre-Budget Report. Then the chancellor serves up the Budget in March and reveals the full details of his plans to the nation. Politics may be a minefield, but thankfully the stock markets are far more predictable in the way they react to Budgets.

Budget day

Share prices generally react favourably on Budget day, rising an incredible 75 per cent of the time in the past 66 Budgets since the Second World War. Indeed, the UK stock market knotched up gains on Budget day in the past four years, rising by 0.3 per cent in 2006, 0.7 per cent in 2007 and 1.6 per cent in March 2008. And although the Budget last year was delayed until 22 April, the end result for investors was more of the same, with the FTSE 100 rising by 1.1 per cent on the day.

The tendency for the market to rise on Budget day is actually very rational. It can be seen either as a relief rally by financial markets that there are no fiscal skeletons in the government's cupboard, or alternatively if the news is good for companies, taxpayers and the economy, investors will react favourably by marking up share prices. In effect, by buying shares just ahead of Budget day you are betting that there will be no nasty surprises in the chancellor’s speech that could unsettle the financial markets – and as our history books show this is a rare occurrence indeed.

Pre-Budget trading signals

Fortunately, we can increase the odds of making a profit on Budget day by looking at how prices move in the five trading days prior to the Budget. Stock market historian David Schwartz notes that share price movements in the range minus 0.7 per cent to 0.9 per cent in this five-day trading period is a great predictor that the stock market will rise on Budget day.

In fact, since 1944 there have been 26 occasions when the UK market moved in this range ahead of the Budget. It went on to rise on Budget day in no fewer than 23 of those years. The two near misses were tiny losses in 1995 and 2001. The market last rose in this five-day trading range in 2006, and true to form investors buying the FTSE 100 on the eve of the Budget were rewarded with a 0.3 per cent gain on Budget day.

Reasons why this happens

The fact that investors react so positively to the Budget when share prices move in this five-day trading range is easy to explain. Bullish, but not overly extended, share price rises ahead of Budget day indicate investor optimism and this positive momentum can easily carry through to Budget day. Equally, if share prices have marked time or made modest losses ahead of the Budget – indicating nervousness by investors - then, assuming there are no unpleasant surprises on the day itself, they are likely to greet the Budget positively as this risk aversion is likely to have been overdone.

Trading Strategy: pre-Budget trade

Share price movements in the range minus 0.7 per cent to 0.9 per cent in the five-day trading period ahead of the Budget is a great predictor that the stock market will rise on Budget day, and is the signal to buy the FTSE 100 through either an ETF, spread bet, covered put warrants, quantos or listed-turbos on the eve of the Budget.

At the end of trading on Budget Day, close out the trade and bank profits if all has gone to plan. It then pays to monitor how the market behaves on the day after the Budget.

Post Budget: trading rules

We can also make money in the weeks following the Budget just by following a few hard and fast rules.

Mr Schwartz points out that when share prices move markedly in one direction or another (outside the range of minus 0.5 per cent to 0.9 per cent) on Budget day and the following day, this is a great signal that the market will be higher 14 trading days later. For example, the UK stock market surged ahead by 1.1 per cent on these two days in March 2007, giving a major buy signal to investors. The index then rose by 1.7 per cent over the next 14 trading days, boosting the coffers of investors privy to these little-known trading patterns.

This was not a one-off, either, as there have been 22 years since 1970 when the UK market has either risen more than 0.9 per cent or fallen by more than 0.5 per cent on Budget day and the day after. Amazingly, 90 per cent of the time the FTSE All-Share was higher 14 trading days later.

Reasons why this happens

It is relatively easy to explain why share prices behave in this manner. First of all, a favourable reaction to the Budget from investors is likely to mean that sentiment will remain positive in the weeks after the Budget, and significantly increases the odds that share prices will rise in the subsequent 14-day trading period.

Alternatively, if share prices have fallen too much following the Budget then it is quite possible that investors have been too harsh in their initial reaction. There is then scope for the market to bounce back as it has done so regularly in the past four decades.

Trading Strategy: post-Budget trade

If the UK market has either risen by more than 0.9 per cent or fallen by more than 0.5 per cent on Budget day and the day after, then it is worth buying the FTSE 100 again to try and profit from upside during the next 14 trading days. Remember, in the past four decades 90 per cent of the time when prices have traded in these ranges the market was higher 14 trading days later.