Is The Santa Claus Rally Real?
Every seasoned trader has heard the phrase “Santa Claus Rally,” but very few understand precisely why it happens. Is it random or is there something structural under the surface that repeats like clockwork each year?
Beyond the whimsical idea of holiday cheer spilling over into the markets, there are structural and behavioral dynamics at play that make the final weeks of the year particularly conducive to market gains.
We unpack the often-overlooked nuances, drawing on insights from options expert Cem Karsan and the mechanics of modern market-making.
Key Points
- Theta decay and delta-neutral hedging by market makers create upward pressure on stocks during the low-liquidity holiday season.
- Long gamma exposure dampens volatility, while fund managers’ year-end portfolio adjustments amplify bullish momentum.
- Thin liquidity, positive sentiment, and reduced tax-loss selling create conditions for the Santa Claus Rally to thrive.
What Is the Santa Claus Rally?
First of all, the term “Santa Claus Rally” refers to the tendency for stocks to rise in the last week of December through the first two trading days of January.
Somewhat astonishingly according to data compiled by the Stock Trader’s Almanac, the S&P 500 has posted positive returns during this period roughly 75% of the time.
A casual analysis points to the rally stemming from seasonal optimism and retail spending but the underlying drivers are more technical than sentimental.
Theta Decay Is A Tailwind for Market Stability
Something very unusual happens in November and December in the markets. It’s the period where the greatest concentration of holidays falls in the year, meaning that it has the fewest trading days per month of any other period in the year, and that means options decay at a faster rate than normal.
That driver hurting option premiums is theta decay and it leads to predictable and accelerated time-based erosion of options premia.
A bullish tailwind is created in the markets because market makers, who supply liquidity to the options market, are forced to manage their books carefully during this period.
When options decay, market makers unwind their hedges, which in turn requires them to buy back stock or indices that they have shorted to stay delta neutral.
The net effect of these unwound hedges is to create upward pressure on the market, especially in periods of low liquidity where smaller trades can move prices significantly.
And because Christmas and New Year’s holidays mean fewer trading sessions, time decay compresses even further. Or in other words, the mechanical unwind of hedges during these shortened windows adds fuel to the stock market rally.
Delta Neutrality Is The Role of Market Makers
Unlike the ordinary investor who makes money betting on a stock rising or falling, a market maker takes home their pay by providing liquidity and an orderly market. That’s only possible by staying delta neutral, meaning their exposure to directional moves in the market is hedged.
When large amounts of call options are purchased as commonly occurs in year-end speculative trading, market makers are obligated to hedge by buying the underlying asset. The net effect is a feedback loop is created whereby rising prices lead to more hedging, which in turn supports further price increases.
Cem Karsan often discusses how dealers being long gamma, meaning their delta hedging adds stability, can suppress volatility and support upward price movement.
During year-end, long gamma exposure in conjunction with lower trading activity tends to add support to this stabilizing effect.
Add to the market makers’ hedging flows the fact that fund managers look to “window dress” their portfolios into year-end reporting and you end up with a sharp bullish bias.
Liquidity & Behavioral Factors
Another ingredient in the mix is liquidity, which typically dries up in late December as institutional traders and large funds step back for the holidays.
Lower liquidity tends to exacerbate the impact of mechanical flows from options markets. For example, in thinly-traded markets, even modest buying pressure from market makers covering delta-neutral hedges can push prices higher.
And with fewer traders around to counteract these bullish inflows, the Santa Claus Rally tends to become a self-fulfilling prophecy.
Over and above the structural factors, behavioral tendencies contribute to year-end market strength, too. By late December, most tax-related selling has come to an end, and so removes a source of downward pressure on stocks.
The holiday season tends to elevate investor sentiment and leads to higher retail participation, which further leans bullish. Many institutions rebalance portfolios at the start of the year, creating expectations of fresh capital inflows into equity markets.
Vol Suppression Translates To “Volatility Vacuum”
The combination of lower implied volatility due to long gamma positioning, reduced liquidity, and predictable flows creates what Cem Karsan might describe as a “volatility vacuum.”
Indeed, he has pointed out in his commentary that periods of suppressed volatility often precede a grind higher in equities.
The Santa Claus Rally is an archetypal example of this phenomenon because when dealers are long gamma, their hedging activity dampens volatility, thereby creating a dynamic that allows markets to drift higher without the usual push-pull of speculative trading.
Is The Santa Claus Rally Guaranteed?
While history supports the Santa Claus rally happening more often than not, especially in bullish years, macroeconomic factors can disrupt this pattern.
Heightened geopolitical risk, Federal Reserve policy decisions, or unexpected economic data can also override mechanical flows.
When volatility, or bearish turbulence, accompanies end of the year moves, the stabilizing effects of long gamma tends to quickly diminish, though.
Similarly, market maker hedging flows tend to support sharper downside moves as opposed to offering bullish support when the economic backdrop is negative.
The Santa Claus Rally Translates to a Market Edge
It turns out that knowing the mechanics behind the Santa Claus Rally translates to having a valuable edge for investors and traders because rather than viewing year-end market strength as a purely behavioral phenomenon, savvy traders can spot structural forces, such as theta decay, delta-neutral hedging, and low liquidity which collectively drive the seasonal trend.
When you grasp the underlying forces, you gain an edge that can exploit volatility decay by selling options during periods of low implied volatility, going long equities or indices during late December to align with structural flows, or even avoiding excessive leverage when macro risks can still derail the trend.
Santa Claus Rally Is No Myth
The Santa Claus Rally isn’t a fable but rather a market phenomenon deeply rooted in the mechanics of options markets and behavioral tendencies.
If you pay attention to the subtleties of delta neutrality, gamma positioning, and theta decay, the rally offers numerous opportunities and as Cem Karsan might say, understanding these dynamics is less about predicting markets and more about preparing for the inevitable forces that shape them.