Tax Day Anomaly in the US Stock Market

Today's study will focus on one of the US stock market anomalies, namely the Tax Day effect (Tax Day).

A Tax Day trading anomaly is an upward trend in the US stock market on the day following the filing date of tax returns.

Steven Moffitt has written about this in his work “The Tax Day Trade: An Efficient Market Anomaly".

He has shown that the strategy of buying the S&P 500 index futures at the end of the Tax Day and selling it at the end of the next trading day has been bringing an average profit of 0.5% since 1980.

Moffit does not give a clear answer about the reasons for this anomaly, but suggests the influence of the irrational behavior of investors associated with the unwillingness to pay taxes and the delay in filing tax returns, or unpreparedness to pay them.

That means that many people postpone the payment of taxes until the last minute. As a result, almost simultaneously, people try to transfer their money into individual retirement accounts (IRA), and being under pressure, brokers are forced to reschedule a number of transactions to the next day.

Stocks included in the DJIA index:

Strategy

Open a long position on indices and stocks:

• at the close of the Tax Day (TaxDay);
• at the close of the day before Tax Day (TaxDay-1);
• at the close of the day, two days before Tax Day (TaxDay-2);
• at the close of the day, three days before Tax Day (TaxDay-3);
• at the close of the day, four days before Tax Day (TaxDay-4);
• at the close of the day, five days before Tax Day (TaxDay-5).

Close a position at the end of the trading day following the Tax Day.

We will evaluate the trading strategy according to the following criteria:

• The average return reflects the relative change in quotations of financial instruments in percentage. A positive value of the average return indicates the profitability of the strategy, a negative one indicates a loss.

The average return (R) of a financial instrument is given by the formula:

where:

n - the number of transactions;

P (%) – the percentage of change in the quotation of the financial instrument at the time of fixing the position, is calculated as follows:

for buy positions

P (%) = (position closing price - position opening price) / position opening price * 100%

for sell positions

P (%) = (position opening price - position closing price) / position opening price * 100%

• The total return (TR) is the sum of the returns from all trades. The greater the value of the total return, the greater the profit brought by the signal during its testing period.

• Max drawdown (MaxDD) is the maximum loss in percentage terms from fixing losing trades for the entire testing period. The smaller the value of the maximum drawdown, the better the trading signal works.

where:

n - the number of trades;

R - rate of return;

TR_n - total return of n trades;

DD_n – drawdown at the time of closing the nth trade;

MaxDD – max drawdown.

Analysis of the obtained results 

Let's look at the results of buying indices and stocks according to the strategy.

So, as expected, US stock market indices and stocks really grow the day after tax returns are filed (TaxDay).

The exceptions are stocks of International Business Machines (IBM), UnitedHealth Group Incorporated (UNH), Goldman Sachs (GS) and Walmart (WMT) (see the appendix for more details).

The average rate of return for indices is 0.35%, for stocks - 0.3%.

In addition, the high rate of return of the strategy with the entry into the market 2 days before Tax Day is clearly noticeable. For indices, the rate of return increases to 1.08%, and for stocks - up to 0.89%.

At the same time, the value of the total rate of return grows for all indices and stocks, except UnitedHealth Group Incorporated (UNH).

The value of the maximum drawdown for indices either does not change or slightly decreases.

Regarding stocks, there is no general pattern in the change of the maximum drawdown. For 11 stocks, the drawdown has decreased, for 19 stocks it has increased.

Another interesting result is that, on average, indices and stocks grow during the seven weeks after Tax Day:

Detailed results are shown in the Appendix:

XLSX (0.04 MB)Tax Day.xlsx