Options have limited risk. Knowing that, some traders are able to use options to play seasonal trends — some of which make sense, some of which don’t.

A trade based on a seasonal trend is one that depends on the calendar for its entry and exit points. Typically, it does not rely on technical or fundamental analysis, although experienced seasonal traders sometimes increase or decrease the size of their bets if there are extenuating circumstances from either technical or fundamental factors.

The essence of trading on a seasonal trend is whether one can profit from using certain such patterns. One example most people in the investment world have heard about is the trend that most returns in the stock markets occur between Nov. 1 and April 30. This concept led to the famous quote: “Sell in May and go away.”

If we were to exploit this adage, a trading system would hedge or liquidate a portfolio on May 1, then re-enter the market on Nov. 1. Options traders could expand on that by purchasing six-month call options in November, with the objective of selling the position sometime before the end of April.

Another popular trading strategy based on a seasonal trend is “window dressing.” The theory is that mutual funds, which must disclose their holdings at each monthend, rush out and buy the hot names so that they are shown in a month-end portfolio listing even though the manager may not have held these securities during that month, when they were actually hot.

In this case, the trader would buy S&P 500 depositary receipts (symbol: SPY; listed on the American Stock Exchange), S&P 500 futures or calls on the S&P 500 three trading days prior to month end and hold them three trading days into the new month because this period, supposedly, has a positive bias.

Lawrence McMillan, president of Morristown, N.J.-based McMillan Analysis Corp. (www.optionstrategist.com), says he is not convinced of this trend’s merits. “Investors aren’t stupid, and they would look more at a firm’s performance than just its monthend holdings,” he says. “Rather, the true nature of this system — if it holds true — is probably that funds make sure their cash balances are low near the end of the month, for they want it to appear that they are working hard for their money.”

The only approach one could take if trying to profit from this pattern, according to McMillan, would be to put money to work during “the first three days of the next month. That’s clearly too late for a fund to be able to list any stocks in its monthend report. But funds do normally get an inflow of money from retirement plans and investment plans at the first of month, as deductions come out of monthend paycheques for investment in the markets.”

McMillan decided to test the potential of the window-dressing pattern by: (1) looking at the results of buying futures on the S&P 500 index at the close of trading on the fourth-to-last trading day of the month and selling them at the close of trading on the last day of the month; or (2) buying on the third-last day of the month, but selling on the close of trading on the third day of the new month. McMillan tested the theory back to 1987, a period of more than 230 months.

Interestingly, both systems made money — but there were some surprises. The first system (exiting a position at monthend) had a 64% win rate (146 wins, 85 losses), but the average win was only 11.4 S&P points, while the average loss was 12 S&P points. An average profit of only 1.4 S&P points is not enough to overcome transaction costs and slippage, the bid/asked spread on the options.

The second system — which requires you to hold for the entire six-day period, three days prior to monthend to three days into the next month — did a little better, with a win rate of 65% (150 wins, 82 losses) and a larger average profit of 4.4 S&P points.

In both cases, you should use only options. By doing so, you would avoid a serious decline such as the one that occurred during the Russian debt crisis of August 1998. With long calls, the most you would have lost back then was the cost of the option.

@page_break@But if you executed the trades with futures or SPYs, it would have resulted in a serious loss that might not have been recovered over the course of the study.

One of the advantages of this system is that a trading opportunity occurs each month. Although McMillan notes, in an attempt to refine the strategy, that “the day before the end of the month has been particularly strong.

“It is as if those doing the buying are trying to outsmart their competitors,” he says. “Or, a more sinister viewpoint holds that they moved their activity forward one day to avoid the month-end scrutiny that now takes place by regulators.”

Also interesting is that this particular strategy has been on a winning streak since October 2002, leading McMillan to opine that maybe this strategy is better suited to bull markets rather than bear markets. It would also suggest that call options be used for this strategy.

To summarize, monthend trading has been a reasonable trading system, although, as McMillan points out, “not as spectacular as some have implied, especially since we know that the majority of the profits are coming from the last three days of the holding period, not the first three.”

There are other trading strategies that revolve around exploiting option expirations, using either the week or the day of the actual expiration. Says McMillan: “These are not related to interpretations of open interest in expiring index options, but rather are pure seasonal trades based on the fact that it’s expiration week.”

One strategy works on the premise that expiration week is generally positive for the market. The idea, then, is to buy the S&P 500 — either calls on the index or SPYs — at the close of trading the week before expiration and sell the position at the close of trading on option expiration day.

This study dates back to 1987; over that time period, there was an average gain of 2.9 S&P points, which is probably tradable.

So, it appears that the best strategy, if you like seasonal patterns, is to buy S&P calls three days prior to monthend and hold for six days. IE