Fed News Volatility

2019-07-31 | Allison Ostrander

Sometimes the Federal Reserve releasing news can be a non event for the market. Other times it can cause the markets to create wild swings up or down depending on the market’s reaction to the announcement. There are several things to keep in mind when a Fed Announcement is going to occur:

1. Is the move already priced in? In the case of this announcement, there had already been talks about the Feds making rate cuts. With the market already aware of this, the move to new highs could have already priced in the anticipation of the Feds taking these rate cuts. Keep in mind the saying “Buy the Rumor, Sell the News.” This could be the circumstance around the announcement today, so even if the news is in line with expectations, there could still be a slight sell off once the event occurs.

2. There will be an increase in extrinsic value prior to the news, and then a bigger drop in theta decay after it occurs. This is due to the uncertainty around the move. If the announcement hasn’t been priced in, or is bigger than anticipated, this could allow for a spike to new highs. If the rate cut has already been priced in, or does not occur, then there could be a stronger drop in the market down to support levels. Sometimes the news will only cause wild swings the first 10 – 30 minutes after it occurs and still close in the same range it was trading in prior to announcement (which creates a non event for the market). In either case, this uncertainty causes an increase in extrinsic value for both strikes in and out of the money on both the Call and Put side. Once the market reacts, and a little time as passed, theta decay snaps back in and the value in strikes decrease. This is especially true of near term or same day expirations.

3. Holding a short term trade on the indexes through the announcement should be seen as a “lotto trade.” Due to the first two points addressed above, holding a trade through the announcement should be viewed as a lotto trade. Much like holding a trade through earnings, anything can happen around this announcement. This means you should be ok losing 100% of the total capital Risk if the market moves against your trade. This is a smart thing to keep in mind so you don’t over invest your account during an event like this. Unless you have time built into the trade, theta decay will work dramatically after the news occurs. That along with the potential move could greatly affect your trade. Ask yourself if you are ok with losing 100% of the capital on that trade. If you start to hesitate, or find yourself getting slightly stressed, then it probably means you have too much capital on, and you should consider reducing it or recycling the capital risk back into your account. If you don’t feel emotional about losing the capital, then it probably means that your capital risk is not overloaded on the trade.

4. If you do have a “lotto trade” you plan to hold through the announcement, have a trading plan in place. This could mean having price targets in place for where the price could move to. This could also mean Closing Orders already in place on lotto trades you are holding through the announcement. This way if the move is quick or sees a strong whipsaw in both directions, you have orders already in place looking to take quick profits. You should also have a plan in place if the trade moves against you, so if you still want to protect some capital Risk you can.

Whether or not you have trades to hold through Fed announcements, it is important to keep these things in mind whenever an announcement is just around the corner. It is always better to be prepared, and have an understanding of what may happen vs getting surprised once the event occurs. As the girl scouts motto goes “always be prepared.” One of the best ways to be prepared as a trader is to have an understanding of your Capital Risk, how the options will be affected by theta, and to have a trading plan in place for trades you hold through the announcement.