This document summarizes a trading strategy known as the "Tax Day Trade" which involves buying the S&P 500 index on the close of the U.S. tax filing deadline and selling the next day. The strategy was not consistently profitable until the 1980s, which coincided with changes to U.S. tax laws regarding individual retirement accounts in 1974 and 1981 that allowed more taxpayers to contribute to tax-sheltered IRAs by the tax deadline. Many taxpayers procrastinate and wait until the last minute to establish their IRAs, causing brokers to delay purchases until the next day, resulting in the post-tax day gains seen in the S&P 500 index.

1. The Tax Day Trade
Market Pattern Research, Inc.
from the book
The Strategic Analysis of Financial Markets
Volume 1: Framework
Steven D. Moffitt, Ph.D.
2016-06-22
c 2016 World Scientific Publishing Co Pte Ltd Privacy Policy and Market Pattern Research,
Inc.(to be published) Not to be cited, reproduced or distributed without express written permis-
sion.
The Tax Day Trade illustrates the Strategic Analysis of Markets Method (SAMM)
introduced in the forthcoming book “The Strategic Analysis of Financial Markets,
Volume 1: Framework,” (SAFMv1) by Steven D. Moffitt, Ph.D. The SAMM intro-
duces a methodology for identifying promising trading ideas and one for converting
them into full blown trading systems.
There are several avenues for discovering promising ideas in the SAMM — the
Tax Day Trade is an hybrid of an event type and a rule-constrained type. For event
types, one locates all events at time zero, forms an aligned dataset of events and their
nearby prices or returns and performs a multivariate analysis to discover tradable
patterns. We omit this part of the analyis, and present its main finding in Figure 1.
The Figure shows cumulative returns for the day after tax day for the 56 years
1960-2015. This strategy can be realized approximately (omitting commissions and
slippage) by buying the close of S&P 500 futures1
on tax day each year, and selling
on the close one day later. Note the strikingly different behavior of cumulative
returns after 1984 — the curve ascends steadily. Despite being a one day trade, it
has averaged about 1{2% per year since 1980.
1
Of course, S&P 500 futures did not exist until April 21, 1982. Details, details . . . , luckily
irrelevant in this case. We also note that commissions were far higher than today during much of
this period, making the trade unprofitable for non-professionals.
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2. Figure 1: Cumulative returns from buying the S&P 500 index on the close of U.S. tax day
and selling on the close one day later. Commissions and slippage not included.
But why is this trade profitable after 1980 but not before? SAFMv1 argues that
using a trading idea for which there is no known mechanism is quite risky because
one has no criterion (beyond price) for abandoning it. To find a mechanism, observe
that the Figure suggests that some precipitating event occurred on or around years
1980-1984. (Note to the reader: (1) when you see an abrupt change in a price or
returns series, look for an explanation, (2) generalize to gain an understanding of how
to anticipate such changes.) Since this strategy is about paying taxes, it is natural to
inquire about changes in the tax law during this period. Here are the most important
changes in tax laws (excluding changes in taxation rates for ordinary income) over
the period from 1950 to 2015 (Source: Wikipedia):
(i) Capital Gains Tax Rate:
1954-1967: Flat 25%.
1968-1977: Variable, but significantly increased
1978-1980: Variable, but maximum 28%.
1981-1986: Flat 20%.
1987-1986: Variable, with maximum at 28%.
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3. (ii) Dividend Taxation:
1954-1984: At individual tax rate.
1985-2002: At individual tax rate with maximum of 50%.
2003-2015: Flat 15%.
(iii) Other Tax Changes since 1974:
1974: Employee Retirement Income Security Act of 1974 (ERISA)
* Established Individual Retirement Accounts (IRAs) with restrictions.
* Deadline for deposit, tax day.
1981: Economic Recovery Tax Act of 1981 (Kemp-Roth Act).
* Allowed all working taxpayers to establish Individual Retirement Ac-
counts (IRAs)
* Deadline for deposit, tax day.
* Expanded provisions for employee stock ownership plans (ESOPs)
1986: Tax Reform Act of 1986.
* Lowered individual tax rates for upper brackets, raised for lower.
From this information and the timing of the post tax day gains that take off around
1980, the most likely tax law changes causing increasing cumulative returns would
be the ERISA (1974) and Kemp-Ross (1981) Acts — laws that govern Individual
Retirement Accounts (IRAs). The 1974 law gave some taxpayers the opportuity to
contribute into a tax-sheltered Individual Retirement Account on or before the tax
day deadline. The 1981 law expanded this opportunity to all working taxpayers.
These accounts are very popular because they do not tax realized capital gains each
year as occurs for ordinary trading (this saves lots of money — do the math and show
why). In current law as of 2016, one can opt to pay no taxes upon contribution but be
taxed upon withdrawal, or pay taxes upon contribution but no taxes on withdrawal.
If you can’t guess what is going on here, you should check with your tax accoun-
tant or investment advisor and ask what people do to establish IRA accounts by tax
day. If you do that, you’ll find that many people postpone establishing their IRAs
until the very last minute. And brokers are then so busy accepting money that they
don’t buy stocks until the next day! Voil`a!
To connect this with investor behavior, you should ask why so many wait until the
last minute. I don’t have a firm answer, but I’d guess that “irrational” behavior may
be involved due to negative affect2
that originates from the associative machine.3
2
Affect refers to a human decision-making heuristic in which feelings, specifically likes and
dislikes, are used to make decisions.
3
The associative machine is the “reflexive” half of dual-process theories of human decision mak-
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4. In plain english, people hate to pay taxes. Therefore, they employ an avoidance
mechanism — procrastination4
— despite this entire behavior leading to a decidedly
suboptimal outcome, that of overpaying by 1{2% on the day after tax day. Note that
post tax day gains are a cumulative effect of millions of affect-induced decisions, and
since affect-induced decision processes lie outside conscious awareness, there’s little
chance that this behavior will change.
There is also a rational explanation. Many have not completed tax preparations
prior to tax day, so they wait until the last day to determine how much they can
afford to contribute.
The first explanation involves irrational behavior, the second rational. Although
both explanations probably hold, I believe that the first underlies the second and
has the larger impact. What do you think?
ing. That system performs cognitive functions rapidly and effortlessly below conscious awareness
using automatic pattern-matching. The other half is the “reflective” consciously-controlled “ratio-
nal” part.
4
The psychology of procrastination is an active area of psychological research at this time.
4