Use This Trade on Wednesday to Play Inflation Panic

Let me take you back in time … to 2018.

At the time, the Federal Reserve was unwinding its balance sheet and raising interest rates, roughly a quarter percentage point per quarter.

When this started in late 2016, it was seen as a healthy move toward getting the Fed’s balance sheet back on track. The market was taking it in stride.

For a while, anyway…

In the Federal Open Market Committee (FOMC) meeting from September 26 to 27, the Fed decided to raise rates to 2.25%.

This raise was, apparently, too much for the stock market to handle. The S&P 500 fell 11% through the month of October. Stocks chopped around violently in the months that followed.

Then came December.

After holding the key rate steady in November, the Fed raised interest rates another 0.25% on December 19 amid the market volatility. The S&P 500 fell another 11% in the following week.

Stocks closed the year down over 6%, the first major yearly drawdown since 2008.

Here’s why I’m telling you this…

Bet on the Fed

The Fed holds significant sway over the market’s direction. It always has, and likely always will.

No matter what you think the Fed should do with interest rates, shrewd traders should be watching each FOMC meeting statement closely.

The FOMC’s two-day meeting starts today. The meeting wraps up tomorrow with a policy statement issued on Wednesday afternoon. Then, Chairman Jerome Powell will hold a press conference.

So today, I want to share my trading plan for this event.

Traders in Treasury and gold markets are watching closely. These markets are among the most sensitive to inflation and the Fed will have to address inflation in its statement. Powell should add more details on what the Fed expects.

For months, the Fed has been saying inflation is transitory. Consumers are starting to worry because higher prices are becoming a problem. The Consumer Price Index (CPI) is up nearly 5% from a year ago.

Somehow, Powell needs to convince consumers that prices won’t keep rising.

Traders in the stock market are likely to take their cue from the action in Treasurys and gold. If those markets are volatile, expect volatility in stocks.

Recent history tells us that the volatility should follow a particular pattern.

The Best Trade for This Week’s FOMC Announcement

Take a look at the chart below, of the SPDR S&P 500 ETF (NYSE: SPY).

(Click here to view larger image.)

The vertical blue lines on the chart are previous Fed FOMC meetings.

The horizontal red lines extend for five days after the meeting. The green horizontal lines extend 10 days after the meeting.

Clear trading ideas emerge from this chart…

Looking at the short term, there was a significant decline in SPY within five days of each meeting.

In February, SPY fell 4% from the close on the day of the meeting to the low. In March, the decline was 3.3%. A relatively small, but tradable, decline of 1.5% followed the May meeting. In June, the decline was 2.3%.

To trade this tendency, buying a put option on SPY while Chairman Powell holds his press conference could be a good strategy. Given SPY’s tendency to fall just a few percent after these meetings, the SPY August 4 $440 put, SPY210804P00440000, could be attractive for this strategy. With SPY just over $440 at writing, it wouldn’t take much of a move for this trade to profit.

But of course, stocks tend to recover after this decline. After 3 of the 4 meetings, SPY was higher 10 days later.

To trade this tendency requires a little more experience. Remember, we are expecting a decline within five days of the meeting. That means it is best to wait for that decline before buying the call to benefit from the expected rally.

Here, too, I would recommend buying an option that’s at the money, to increase your odds of profiting.

Regards,

Michael Carr, CMT, CFTe
Editor, One Trade

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