Hot stuff: How to trade on good weather without getting burnt

Using data on 13.82m cab rides from January to October 2009 in New York City, combined with statistics on hourly levels of solar radiation, a recent study entitled “Taxicab tipping and sunlight” found a significant positive relationship between sunlight and tipping.

The study, by Srikant Devaraj and Pankaj Patel from the Miller College of Business and the Villanova School of Business, found an estimated tipping increase of 0.5 to 0.7 percentage points when transitioning from a dark sky to full sunshine.

But if people tip more on sunny days, what about the possible impact on more consequential financial decisions? Can this small but reliable effect also have implications for the stock market? Is that a hot tip on an effect powerful enough to move the stock market?

Read more: Retail sales fall on weather hit but department stores provide bright spot

Can you trade on the weather?

According to professor David Hirshleifer of the University of California at Irvine and professor Tyler Shumwa of the University of Michigan, the answer is a resounding yes.

Although several research studies have confirmed that sunny weather can positively impact the stock market and other financial indicators, their study, “Good Day Sunshine: Stock Returns and the Weather”, remains one of the first and most seminal in the area of weather forecasting market movements.

It examined the relationship between morning sunshine in the city of a country’s leading stock exchange, and daily market index returns across 26 countries over 17 years. Sunshine was strongly significantly associated with stock returns. The difference in expected return between a completely overcast day and a sunny day was found on average to be about nine basis points – though this could climb to approaching double this in some trading centres, such as New York.

The study also found that traders could make money with an investment strategy based purely on predicting market movements from weather. There was potential profit in trading on the sunshine. However, because weather can be very changeable, this investment strategy would involve a lot of trading, so if transaction costs were high, this would begin to eat away at profits.

The authors argue that there must be something psychological going on to explain this effect, since the impact of sunshine applies to markets across the globe.

Hirshleifer and Shumway contend that, if people are more optimistic when the sun shines, they will be more inclined to buy stocks on sunny days.

This is a “mood” theory – if people are put in a positive frame of mind, this affects the way they trade.

If you can predict that the market is going to be in happier emotional states because of the weather, you can exploit this powerful and reliable forecast about market movements during clear skies. As long as the move is reliable, it doesn’t have to be stratospheric to be the basis for profitable trading.

Psychologists might place particular emphasis on unexpectedly good weather, because this has more impact on mood, than experiencing balmy day after balmy day in the middle of summer, where getting used to good weather will have less of an impact.

Another theory to explain what must be an irrational but widespread basis for trading is that traders incorrectly attribute their better mood to positive economic prospects, rather than to good weather. When you are happier, you find reasons for that positive emotional state in economic indicators (when the real reason is blue skies and warm weather), and this leads to more optimistic investment.

The “sunny days mean the market moves up” finding makes a prediction – it is not that a forecast of sunshine causes positive stock price reaction. Rather, it is the occurrence of the sunshine itself that heats up the prices.

Hirshleifer and Shumway caution against using weather as a trading strategy, and instead suggest that the really useful implication of their finding is that investors can benefit from becoming more aware of their moods, in order to avoid mood-based errors in their judgments and trades.

Another implication is that the weather forecast could be a more reliable predictor of your future mood than even you might be, even though you know yourself a lot better than the meteorologist on TV.

Psychologists have long known that people have trouble foreseeing their future moods and how this will affect impending behaviour, a phenomenon known as “projection bias”. But if you know the day is going to be unexpectedly sunny, it’s possible to reliably predict your mood later in the day – and also forecast the mood of the market – much more reliably than you might have guessed.

Unfortunately, this finding probably means you should be exploiting sunny days for a trading edge over the market, rather than taking the day off and catching some rays.

But profits generated by trading on the weather might pay for retirement to somewhere with more reliable sun.

Read more: Bad weather will (temporarily) reduce UK GDP growth say forecasters