Does the Fed Create or Just React to Volatility?

Dear Slingshot Trader Subscribers, 

It’s hard to write too much about the direction of the market during the next few weeks the day of a very pivotal FOMC announcement. However, that may actually be just the topic to discuss this week as we try to explain how it could change the way we are positioning ourselves and what kind of trades we are looking for.

First, a Little Background

The Federal Open Market Committee (FOMC) announcement is released approximately eight times per year and includes a statement about Fed’s discount and overnight interest rate targets. The announcement has recently been expanded to include information from the FOMC committee members that provides more detail about their outlook and opinion of economy and monetary policy.

It is safe to assume that the Fed isn’t going to be moving interest rates any lower (hard to be less than 0%) in the near term and the FOMC has already informed the market that those rates won’t be rising this year (or likely next year, either) anyway, so investors will be much more focused on the vague and nuanced comments about the economy, inflation, and the potential for future easing.

Does the Fed Affect Stock Prices Every Time?

The last few announcements have been accompanied by a nice trend in the market, but things have been changing quickly. First, the major stock indices have reached low but reasonable technical-targets following the November rally and are looking “toppy.” We would expect that if everything remains relatively constant, a channel will emerge and stocks will trend flat. However, a lot of that depends on what the Fed decides to do in the short term.

A few major European economies including Spain and Italy are in a double-dip recession and the U.K. joined them today. Economic strength in Europe matters a lot to the Fed because it could have a direct impact on the U.S. economy and labor market. In fact, the robust rally that started last November was triggered by easing the Fed initiated in the Eurozone. It may sound weird for the Fed to be managing monetary policy through European central banks but whether it will do it again will be one of the things traders will be talking about today.

The FOMC statement is intentionally vague so the reaction by traders will likely be based on several layers of interpretation and assumptions. As you can imagine, this is probably more of a reflection of the general market environment than the actual words used in the statement itself. This leads to a problem with the FOMC announcements. With the exception of the January 2012 report, FOMC announcements are highly correlated with higher market volatility but isn’t clear, which one causes which.

For example, in the next chart you can see the last few FOMC statements (including unscheduled announcements) over the last year. It seems that the FOMC has an uncanny ability to release its announcement during periods of heightened price volatility or potential reversal levels. We don’t think this is a coincidence and are, therefore, expecting that the average price movement in the major stock indices is likely to remain larger than average in the short term.

 

Dow Jones Industrial Average w/ FOMC announcements: Chart Courtesy of MetaStock

Why Volatility Can Be a Good Thing …

Large daily trading ranges can be good for option traders – especially if overall implied volatility levels stay out of “panic ranges.” Options are a wasting-asset for a long trader, which means that every day the position is held, a little time-value erosion eats away at its value. If the stock does not move, the option will lose value but a volatile market makes this time value erosion less of a concern. However, that also means that the potential ups and downs are much larger on a day-to-day basis, as well.

… Except When They’re Not.

A position entered today in a fast, directionless market could rise or fall 50% or more on a day-to-day basis. In a market like this, whipsaws can be common for traders using tight stop-losses as their primary method of risk control. We have felt for a long time that this ignores one of the primary advantages of long options, which is their fixed risk and unlimited upside. Although an option’s price could rise an unlimited amount, it already has a max loss or embedded stop loss of the total premium.

That may sound a little weird for investors used to trading stocks, but because the kind of options we are trading are highly leveraged, the volatility levels are just too extreme for the kind of risk control that might be applied to a stock. Option investors are much more likely to rely on position sizing and portfolio diversification to manage risk without a stop. In today’s webinar, we will do a short review of what this means and why option traders use small but consistent position sizing to deal with choppy markets without risking frequent whipsaws. The webinar starts at 6 p.m. Eastern, so join us by clicking here.

The Bottom Line for This Week

Unless the FOMC does something really unexpected, we think the market will remain channel-bound in the short term. Reaction to the announcement is likely to increase volatility, or at least keep it as high as it is currently. This will put more pressure on us to make sure we are looking at option prices very carefully before entering a new trade because it will be easier for them to become ‘mispriced.’

Here are some of the news events that we may trade in the next week or so. We’ll be discussing some of these in tonight’s webinar.

April 26 – Exxon Mobile (XOM) Earnings

April 26 – United Parcel Service (UPS) Earnings

April 26 – Deckers Outdoor (DECK) Earnings

April 26 – Bunge Ltd. (BG) Earnings

April 26 – CoinStar (CSTR) Earnings

April 27 – U.S. Advance GDP

May 1 – U.S. Manufacturing PMI

May 2 – ADP Labor report for April

May 2 – Visa (V) Earnings

TRADE REVIEW

When it’s time to open or close a trade, we’ll send you alerts via e-mail. You also can sign up to receive text messages regarding our trades. For more info about our SlingShot Trader portfolio, you can read trade alerts here and view our portfolios here.

 

Open Positions

These are the SlingShot Trader positions we opened during the past two weeks of trading that we have not yet closed.

Bunge Limited (BG) – On April 23, we recommended you to “buy to open” the May 65 puts for $1.91 or less. We still like this trade and recommend entries at our maximum price or less.

Deckers Outdoor (DECK)– On April 24, we recommended you to “buy to open” the May 60 puts for $1.25 per share or less. We still like this trade and recommend entries at our maximum price or less.

Coinstar (CSTR) – On April 25, we recommended you to “buy to open” the May 67.50 calls for $1.89 per share or less. We still like this trade and recommend entries at our maximum price or less.

 

Positions Closed

These are the SlingShot Trader positions we closed during the past week of trading.

Aetna (AET) – On April 25, we recommended you to “sell to close” the May 50 Calls. We closed the position for $1.33 per share for a gain of 10%.

DR Horton (DHI) – On April 23, we recommended you to “sell to close” the May 14 puts. We closed the position for $0.17 for a loss of 63%.

Kimberly Clark (KMB)– On April 20, we recommended you to “sell to close” the May 75 Calls for $1.82 per share for a gain of 68%.

American Electric Power (AEP) – On April 20, we recommended you to “sell to close” the May 37 puts for $0.32 per share for a loss of 61%.

Whirlpool (WHR) – On April 20, we recommended you to “sell to close” the May 65 puts for $3.70 per share for a gain of 39%.


Webinar Preview: Join Us Tonight at 6 p.m. ET

Every Wednesday at 6 p.m. ET, we host our live webinar, in which we’ll review this weekly newsletter, discuss coming events in more detail and walk through our Top Trades. We also encourage you to submit your questions live during the session. We want to do everything we can to help you become a successful options trader, which is why you’ll have live access to us for an hour every week.

And if you have any questions or comments you would like to send us in advance of the live session — or anytime during the week — you can write to us at johnandwade@slingshot-trader.com.

If you can’t attend the session live, you can watch the archived version on our website in the “Live Weekly” section. It’ll typically be posted within about two hours of the end of the live session. 

Sincerely,

 

John Jagerson and Wade Hansen
Editors
SlingShot Trader