Today the Federal Open Market Committee (FOMC) kicks off its final meeting for 2018. The market has largely priced in the expected rate hike. But that doesn’t mean a meeting of this magnitude will be left as settled business even if the group does hike rates as expected.
Wall Street is a fickle place. It generally hates interest rate hikes. But it can also hate Fed meetings that end without a hike. This is one scenario we face this week.
What if the Fed doesn’t hike rates tomorrow? To many, that would signal that the Federal Reserve believes the economy is going to slow even more than previously expected. That would send stocks down.
What if the Fed does hike rates and continues to forecast “gradual increases” to its target rates? That too could send shares down. You see, investors might expect that kind of move. But that doesn’t mean they will sit by and accept another year of quarterly rate hikes without selling off some of their positions.
Finally, what if the Fed hikes rates but stops signaling future rate increases? This is a tough scenario to forecast. What this would tell the overall investment community is that the Fed is sticking with its intended policy action, despite the recent tweet from President Trump trying to stop them. However, it too might signal that the Fed is going to just ignore the recent downturn in stocks. This could send investors into a short-term panic.
Alternatively, a hike without language signaling future hikes could be taken to mean that the Fed’s previous policy worked and interest rates are now sitting in the sweet spot. That could trigger buying in the market after the last few weak months.
Notice what all of these potential Fed outcomes have in common? In no scenario does the market sit still. No matter what the Fed does, it appears, investors are poised to act.
Of course, with the close of 2018 in sights, we are already in a volatile period. This meeting could just be the icing on the cake.
So, how could someone play a scenario like this? We don’t know what the Fed will do or say. But we know that stocks will likely make a large movement following the announcement. This calls for a strategy we have discussed several times… one that works best in a high volatile but uncertain environment.
A Strategy to Profit From Expected Volatility
A long straddle trade is one that involves buying two options. Since there’s no offsetting short option leg of this trade, it is a debit trade. Meaning, a long straddle costs the trader money to enter it. But the risks of the trade are capped at that amount.
The reward for a successfully executed long straddle is virtually limitless. You can see how that works here:
Source: The Options Industry Council
To enter a trade like this, one would have to purchase a call option that is at or near the current trading price of the underlying security and then purchase a put option at the same strike price and with the same expiration date.
The beauty of this kind of trade, as you can surmise, is that it doesn’t matter which direction the underlying security moves. If the price of the stock or ETF moves down, the put leg of the trade will return a profit. If it moves up, the call option will trigger a profit. If those shares or notes move far enough, those profits will outpace the debit it took to enter the trade.
Let’s look at a specific example using our current market situation.
A Specific Trade For Year-End Volatility
Let’s say you believe the market is going to react strongly, one way or the other following tomorrow’s Fed announcement. Before you pick which underlying security you would want to trade, consider which parts of the market will react the strongest to this news.
We’re talking about interest rates here. There might not be any industry more closely tied to this specific topic than real estate. After all, whenever the Fed changes its policies, it directly affects what both lenders and borrowers do, the supply and demand for housing, commercial properties and refinancing.
A great way to play such a massive sector is the Vanguard Real Estate ETF (VNQ). VNQ holds all kinds of real estate investment trusts, including everything from commercial and real estate properties to public storage companies and the owner of cell towers. It is a true broad market play on real estate.
So, when looking to make a long straddle trade on interest rates, there’s no better way than to use VNQ as the underlying ETF.
To enter a long straddle on VNQ, you could purchase a January 18 $78 call for $1.45 and a January 18 $78 put for $1.85 for a cost of $3.30 per share. Since each option represents 100 shares of VNQ, this trade works out to a net debit of $330.
That’s the total you’d have at risk if this is how you play year-end volatility. And as we noted, the upside is limitless. No matter what the Fed does, it looks like a big market move will follow. VNQ, while not normally a large mover, would certainly join the overall market on this one.
To find the point at which this trade becomes profitable, simply take the strike price for both options and compare it with the total cost to enter the trade. So, $81.30 ($78 + $3.30 = $81.30) is the point at which the call option would become profitable enough to cover the cost of the trade. Likewise, $74.70 ($78 – $3.30 = $74.70) is when the put reaches that threshold.
As you can see in the above chart, VNQ has been trading in this range the past few months. This represents a 4.2% move in VNQ shares for this trade to hit profit territory.
With so much riding on this announcement, not to mention the overall anxiety many real estate experts are feeling these days, that kind of movement is a real possibility. In fact, a breakout on one side or the other of this trade is likely.
And that is how you get a limitless upside no matter what the Fed does tomorrow afternoon.
— The Option Specialist