Fun with the FED!

Some of you love em’, some of you hate em’, but whatever your opinion is of Ben Bernanke and company, we have to at least give them some respect for what they do. My mother told me a long time ago that if you’re going to criticize someone, be sure you can offer a better solution. The point of this article is not to offer Dr. Bernanke criticism, but to see if we can profit from the decisions that he makes.

The markets will obviously react when the Fed speaks, but this reaction can sometimes be misleading and muted. Like a highly anticipated earnings report, the point is that, as an options trader, we have tools in our arsenal for just this sort of thing. Trading around the FOMC meetings can certainly add risk to your trades. Before just taking a flier, either long or short, take a step back and assess the situation. For those of us who don’t have a direct line to the Chairman and to every single market participants around the world, for that matter, it’s really a matter of "feeling out the market" combined with statistics. The markets have rallied during each of the past four FOMC meetings, but it’s more than that, it’s about being attune to volatility and cognizant of what the markets did up until that point.

Market Moves on Recent Fed Decision Days:

• December 16, 2008: Dow Jones Industrial Average (DJIA) up 4.2%, 10-year Treasury yield down 0.17 percentage point.
• January 28, 2009: DJIA up 2.5%, 10-year Treasury yield up 0.14 percentage point.
• March 18, 2009: DJIA up 1.2%, 10-year Treasury yield down 0.47 percentage point.
• April 29, 2009: DJIA up 2.1%, 10-year Treasury yield up 0.09 percentage point.

Source: Federal Reserve, WSJ Data Group

For instance, going into this past meeting, the S&P 500 Index (SPX) was at the lower end of its recent range at about 900 (903 being support). Implied volatility was looking a bit rich compared to what the index was moving at. So here I pieced together a few facts:

1. The past four meetings have had bullish repercussions on the index.
2. The market had recently come down to support.
3. Bernanke was not supposed to say anything surprising, but it was suspected he might give some indications of future rate action by the FED or its Treasury purchase program.
4. Volatility was relatively low and no major earnings were due for a couple weeks.

With all this data, I might be willing to take a moderately bullish position in the SPX and possibly a short vega position based on my opinion of volatility. Maybe the sale of an out-of-the-money July put might be the best medicine in this case. As an options trader, I can have a multitude of ways to attack the situation that is presented in front of me. If I had a moderately bullish stance, but believed that volatility was a bit overbaked and I was okay owning the SPX (or the related ETF, the SPDR S&P 500 [SPY]), I could sell the 860 (or 86) put, which would certainly give me some downside risk, but not as much risk as buying the index or the ETF outright.

There are certainly a multitude of ways a trader can play the FOMC meetings; this is just one simple way a trader can take advantage of volatility with a bullish outlook and potentially lower his or her risk versus buying a stock, ETF, or index.

Don’t forget to paper trade and do your homework, as this strategy as well as others involve risk and should be thoroughly understood before applying real money.