The Santa Rally is a phenomenon that’s more known among stock traders, but still can have an important impact on Forex. Generally, stocks rise towards the end of the year thanks to several factors, including portfolio readjustment, tax preparation and a general sense of positivity ahead of and between the holidays.

For Forex, this often translates into improved risk-on sentiment. So, generally speaking, commodity and emerging market currencies tend to outperform safe havens, such as the dollar and the yen. The latter in particular was affected this time around because of the recent BOJ decision to not do anything. And the dollar had already been trending lower ahead of the holiday season as investors priced in increasing chances that the Fed will turn more dovish.

It’s a Funny Time of the Year

Traders that were betting on a smooth rise through the rest of the year got a pretty jarring surprise on Wednesday when US stocks just fell for no reason. That was literally the explanation given by most experts. The benchmark S&P 500 was approaching a near record high, and then suddenly dumped 1.5% (though it recovered a bit by the end of the day).

These sudden drops in the stock market – and the commensurate shift in risk appetite – are not rare. Last year, the Dow tanked 765 points in one day on December 15th. At the time, analysts pointed to recession fears, but that didn’t turn out to be the case. Often after these sudden drops, the market simply returns to its prior trajectory.

Why All the Fits and Starts?

Defying a specific explanation, markets are just more volatile in the final couple of weeks of the year. This might be frustrating for traders seeing the market move for no apparent reason. But, as the holidays approach, there is little in the way of big market data. And many of the big market-making traders and institutional investors take time off for vacation.

That means there is a perceptible drop in volume as well as liquidity in the markets. Small actions that would hardly ripple in the stock market now can make big waves. This leads to much sharper market moves – in both directions. This higher volatility and unpredictability naturally keeps many traders away from the markets, which only exacerbates the issue of low liquidity and volumes which lead to higher volatility.

Investment Opportunity or Risk?

Through this period, retail traders tend to dominate the markets. And smaller traders are often more optimistic than their institutional counterparts, which contributes to a general risk-off sentiment despite the higher volatility. Traders who wish to take advantage of the situation need to be aware of the unusual characteristics of the period, and understand that their strategies that work in normal conditions might not perform as well.

In the end, cold-headedness typically prevails in the market. Keeping risk within reasonable bounds and focusing on maintaining adequate stop losses often generates better results in higher volatility markets.

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