Trading the Fed Announcement

It has been quite a while since a Fed announcement has been talked about as much as this one due on Thursday (2pm Eastern).  And there is wide debate on what the announcement may cover, and should cover (see For the first time in years, Fed decision is truly a toss up).

The main point centers on whether the Fed should begin a cycle of raising interest rates. With any change in the interest rate structure, there are businesses that will benefit, and there are businesses that will be hurt. Place your bets, the race is about to begin.

We've already entered a new stock market phase of higher volatility. Wednesday's announcement could be followed by a sharp reaction by traders – heavy selling or buying. There could even be wide swings between the two.

If you are a stock-only trader, there are a few ways you can prepare for a significant movement in the markets. The most conservative approach is to lighten your exposure by closing some or all of your positions. You could also buy ‘protection', such as inverse sector ETFs. There aren't many ways to play a large movement in either direction. Your best option may be to buy VXX, which trades according to the current volatility level, the VIX.

If you trade stock options, then your ‘options' expand. Even traders who are relatively new to the world of option trading might think about a ‘straddle', an option strategy where you take a ‘non-directional' bet by buying both a call and a put at the same strike.

Let's see how that might work in this situation. I'll focus on the SPY, which is the ETF based on the S&P 500 index.

The SPY is currently down 8% from its mid-May high, after falling as much as 14.7% three weeks ago. Say the S&P 500, and therefore the SPY, reacts as much as 5% in response to the Fed either raising rates on Thursday, or deciding to leave them as is and therefore frustrating a component of the market that just wants this uncertainty to stop.

Looking at the SPY daily chart, a 5% move certainly seems possible, given the recent range of movement. It may not happen immediately, but depending on the tone and content of the Fed announcement, the market could move 5% or more within the week or so following the announcement.

So let's consider an option straddle strategy and see how it might work in this situation. A straddle loses money if the underlying security or index remains within a tight range, and makes money if there is significant movement to outside of the range.

The SPY is currently at 196.74, about mid-way within the recent wide trading range. It may take a few days, or even a few weeks, for the S&P 500 to move around 5% or more, so we don't want to consider SPY September 18th expiration options – that may not be enough time for this trade to work.

Let's use October expiration options. So a straddle trade on the SPY would be implemented by buying equal amounts of the SPY October 197 Calls and October 197 Puts (assuming SPY opens this morning near Friday's close of 196.74).

I put quote marks around the phrase ‘non-directional' above. When traders first learn of straddles, they are usually told that a straddle is a non-directional bet. You make money as long as the underlying moves a certain amount, and it can be in either direction.

But a straddle actually has a directional bias, and we must consider that for any trade. The key to it is ‘Implied Volatility' (IV), the component of the pricing of options that relates to perceived volatility.

Looking at the past year's chart of SPY's IV, we see that it is in the middle of the recent swings. Prior to August, the current IV of 20 would have been on the high side. But after recent market swings, an IV of 20 is mid-range:

A straddle is the BUYING of calls and puts, and the best way to increase your chances of success when buying options is to buy them when the Implied Volatility is near the bottom of the past year's range. That will not be the case here. IV is in the middle of the range. But can we still make money?

The reason I say the straddle strategy actually has a directional bias is IV typically falls as the underlying moves upwards, and typically increases if the underlying drops. Since IV is a major factor in the pricing of options, this can drastically affect the potential Profit/Loss picture of this trade strategy.

Here are the theoretical possible profit/loss numbers of a SPY October 197 straddle, if purchased this morning at Friday's closing prices.

The focus is on September 25th, 10 market sessions from now. This is a week and a half after the Fed announcement, which should be adequate time for the markets to respond to the Fed announcement and the index to make most of its move (if any).

If the perceived volatility of the options, the IV, stays around 20, then our breakevens are around 189.73 and 203.80. We'll theoretically make money if SPY is below or above those prices on 9/25 (or sooner). If SPY drops 5%, our straddle could make 17%. If SPY gains 5%, we could make 17%. It seems a pretty balanced bet.

But if we factor in the fact that IV will likely change with any movement in SPY, the analysis shows the trade has a directional bias.

If SPY's IV increases to 25%, which is possible if SPY drops significantly, the breakevens on 9/25 actually become non-existent – this trade will theoretically make money no matter what. If SPY were to drop 5% and IV increased to 25%, then the straddle trade could be up 26%.

If SPY's IV drops to 15%, which is possible if SPY moves upwards, the breakevens move outwards. SPY may have to increase to around 205.73 by 9/25 before we start making money. And if SPY was up 5%, we see that we may only make around 6% on the trade.

So the best scenario with a straddle strategy would be for SPY to fall 5% or more, although we could potentially get out with a small profit even if it rose. But this is a directional trade. You would need to believe the odds are higher that the S&P 500, and therefore the SPY, will fall post-Fed. If that's what you believe, a SPY October straddle offers a good trade opportunity.

And you do not have to hold the straddle until the October 16th expiration date. To raise the probability of success with a trade like this, target a profit in the 15% to 25% range, and exit the trade as soon as you can with that price target (a sell stop to close will work nicely). You may be in the trade for only a few hours after the Fed announcement, or maybe even just a few minutes.

Of course, there's much more you need to know and many more stocks you can capitalize upon each and every day.  To find out more, please click on the following link: www.markettamer.com/seasonal

By Gregg Harris, MarketTamer Chief Technical Strategist

Copyright (C) 2015 Stock & Options Training LLC

Unless indicated otherwise, at the time of this writing, the author has no positions in any of the above-mentioned securities.

Gregg Harris is the Chief Technical Strategist at MarketTamer.com.

The content on any of Market Tamer websites, products, or communication is for educational purposes only. Nothing in its products, services, or communications shall be construed as a solicitation and/or recommendation to buy or sell a security. Trading stocks, options, and other securities involve risk. The risk of loss in trading securities can be substantial. The risk involved with trading stocks, options and other securities are not suitable for all investors. Prior to buying or selling an option, an investor must evaluate his/her own personal financial situation and consider all relevant risk factors. See: Characteristics and Risks of Standardized Options (http://www.optionsclearing.com/publications/risks/riskstoc.pdf). The www.MarketTamer.com educational training program and software services are provided to improve financial understanding.

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