It's time to consider The January Effect.

If you already understand that supply and demand determine prices, then you'll quickly grasp how to trade the "January Effect".

We hear a lot this time of year about the "January Effect." The name suggests that it happens only once a year, so it is understandable why many investors don't bother to learn what it is. But there really isn't anything mystical going on, and its influences are quite normal.

The January Effect happens when it does because of the United States Tax Code. Wake up!! Sorry.., thought I saw you dozing off there when I mentioned the United States Tax... wake up! Seriously, you don't need to be a CPA for this exercise, you just need to understand that tax consequences on your portfolio are based on whatever happened during a single calendar year.

In other words, if you close out a position in your portfolio before the market closes on December 31, then its profit or loss should be considered in calculating your 2007 taxes. This is not an investment decision. To be sure, the decision to sell may be purely for investment reasons. But unlike any other time of year, that can be augmented and perhaps even overshadowed by tax considerations.

The loss taken on one stock can offset an equal gain from another stock. If I sold a stock earlier this year for $8000 that I bought previously at only $5000 (yes, I'm just that good) then I must declare a $3000 gain to pay taxes on. If I have another position worth $5000 that I originally bought for $8000 (yes, I'm just that good) then I can sell it and avoid paying taxes on the other stock's gain. At year-end, investors are more likely to sell their losing positions. So, under performing stocks tend to continue under performing into year-end.

Investors can sell a stock at a loss in January and still get the tax benefit, but they won't get that benefit until after year-end. So, this selling pressure suddenly disappears when the market closes at midnight December 31, when the time value of money meets human nature of not wanting to admit being wrong. Now add another reason to sell: the tax loss that can help to avoid paying some taxes a couple of months later. This increases supply, which makes price decline further.

Well, this sounds easy, right? Look for stocks that have been declining, find the ones that decline even further into December 31, buy them when the market re-opens on January 2, then choose between the red Ferrari or the black one. Too easy. Firstly, those bad-boys Ferraris are so.. last decade. To keep up with the times, think Lamborghinis instead!

In reality, everyone and their dogs have already figured out this strategy's timing. Buyers are already acquiring their positions well before year-end, anticipating the January Effect rally, even while some shareholders continue selling to realize their tax loss. We can take out some of the guesswork by limiting our choices to stocks that already stopped declining, or else those that are trying to bottom. I like to see price momentum indicators like MACD & RSI giving buy signals, and I also like to see Money Flow or On-Balance-Volume indicators under accumulation. Even if all systems say "go," the actual impact of the January Effect rally should subside by month-end.

By the way.., the season is changing, Winter Solstice is just round the corner - 21st Dec 07, and market will experience a directional change too.