History tells us there's often a major disconnect between technicals and sentiment in late December and market action in early January. End-of-year window dressing, light holiday volume and retail tax selling all combine at this time of year to yield unique market dynamics that tend to go "poof" once the calendar flips into January.

You've probably noticed that the strongest stocks of 2009 have gotten even stronger in the last two weeks. This resiliency makes sense -- investors don't want to sell their biggest winners so close to year-end and get hit with capital gains tax. So they wait until the start of January, when the prior year's leadership often gets dumped aggressively.

On the flip side, many of this year's biggest losers could attract aggressive buyers in January, because risk appetite is expected to grow exponentially with 12 new months on the calendar to turn an annual profit. This positive seasonality contributes to the classic January Effect, which favors small-cap and underdog performance.

As we pass through the door into 2010, keep in mind that trading strategies based on December momentum usually turn out to be unprofitable, and even dangerous. A better approach is to capitalize on the expected dynamics of a shiny new market year. In that regard, here are three swing trades that take advantage of typical January seasonality.

1. Sell Short Nvidia

Nvidia (NVDA)
Daily
eSignal
Sell short Nvidia ( NVDA) on or near the last trading day of the year and cover into January selling pressure. This stock has been going vertical in recent weeks and has now filled a huge July 2008 gap between $13 and $18. This is a natural sell zone that combines with the likelihood of a January pullback in chip stocks, which are now bona fide market leaders.

This is a high-risk play for experienced traders with solid risk management skills. If you're interested in the trade, keep position size small and place a stop loss above this week's high in order to avoid a January "jolt" prior to a decline. This leadership issue shows unfilled gaps near $16 and $14. These holes mark obvious price levels to take profits.

2. Buy a Basket of Small-Cap Losers

I've compiled a list of higher-volume Russell 2000 index components trading over $3 with the weakest relative strength heading into year-end. Buy a basket of three, four or five of these issues to take advantage of small-cap seasonality and the end of tax-loss selling pressure. Keep total dollar exposure in each component uniform to manage risk across the basket.

The basket should be held in one unit into the third or fourth week of January, with a total dollar stop loss, which sells all positions at once if the trade fails. In other words, don't try to time the market and reconfigure the basket because one stock has a bad day. When the target date is reached, close out all positions or keep a few winners to play into February and March.

This list of Russell 2000 losers could make a basket trade worth the risk:
  • Novatel Wireless (NVTL)
  • Huron Consulting (HURN)
  • Englobal ENG
  • Sequenom (SQNM)
  • STEC (STEC)
  • Cathay General Bancorp (CATY)
  • Eagle Bulk Shipping (EGLE)
  • Isis Pharmaceuticals (ISIS)
  • Energy Conversion Devices (ENER)
  • Pantry (PTRY)

3. Find Small-Cap Winners

The turnaround play is a great way to trade the January market, but an even better strategy is to find the next hot stock while it's still in its embryonic stage, waiting to be discovered by the chat room crowd. For this strategy, I flipped through weekly charts of Russell components, picking out issues that look poised for even higher prices.

These Russell 2000 small-caps could break out in early 2010:
  • Uranium Energy (UEC)
  • Ulta Salon (ULTA)
  • Aruba Networks (ARUN)
  • Valassis Communications (VCI)
  • China Information Security Technology (CPBY)
  • SuccessFactors (SFSF)
  • Switch and Data Facilities (SDXC)
  • Ticketmaster (TKTM)
  • BPZ Resources (BPZ)
  • Omnova Solutions (OMN)
Happy New Year, everyone!


Please note that due to factors including low market capitalization and/or insufficient public float, we consider NVTL, HURN, ENG, SQNM, CATY, EGLE, ENER, PTRY, UEC, CPBY and OMN to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

At the time of publication, Farley had no positions in the stocks mentioned, although holdings can change at any time.

Alan Farley is a private trader and publisher of Hard Right Edge, a comprehensive resource for trader education, technical analysis, and short-term trading techniques. He is also the author of The Daily Swing Trade, a premium product from TheStreet.com that outlines his charts and analysis. Farley has also been featured in Barron's, SmartMoney, Tech Week, Active Trader, MoneyCentral, Technical Investor, Bridge Trader and Online Investor. He has written two books: The Master Swing Trader and The Master Swing Trader Toolkit: The Market Survival Guide, due out in April. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks.

Farley appreciates your feedback; click here to send him an email. Also, click here to sign up for Farley's premium subscription product, The Daily Swing Trade, brought to you exclusively by TheStreet.com.

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