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Option Basics: How to Trade the FOMC Announcement

Trade Results
Trade Results

We had recently written an article titled "Impact of the FOMC on the Markets". In this article, we will be looking at how you can trade the volatility expansion prior to the announcement and the expected collapse of volatility after the announcement; typically described as a binary event.

Tasty Trade performed a test in which it looked at the eight annual announcements over a 6-year period. Prior research conducted by Tasty Trade indicated that only 13% of the moves had magnitudes greater than 1.5x the average daily move by the following Friday; and that volatility (as measured by the VIX) dropped 0.50% by Friday. In our testing, we found the duration of important FOMC announcements averaged 2.3 days before reversing (the reversal lasting an average of 2.9 days). So it is clear from both tests that FOMC announcements can have an impact with a duration that lasts more than one day.

To determine if a Strangle strategy at 1 SD (standard deviation; level of risk) would be profitable, Tasty Trade tested two ETFs: SPY (S&P 500 index) and TLT (20+ year Treasury Bond). A position in each would be initiated at the Close on Tuesday (the first day of the FOMC meeting) and then checked at the Close on Wednesday (after the announcement) and again on Friday at the Close.

The results (see Table above): As a guideline, at 1 SD the POP (probability of profit) is 68%; so we would expect the Percent Winners to match the POP. If we closed our position on Wednesday, we would have a loss for both SPY and TLT, with a Percent Winner of 66.67% and 64.58% respectively; these results reflect that the IV (implied volatility) did not contract enough (if at all).

However, if we waited till Friday to close the position, both SPY and TLT were profitable; an indication that IV contracted sufficiently to make this strategy viable. The Percent Winners of both improved dramatically exceeding the expected POP: 85.42% and 81.25% respectively.

In conclusion, if we want to trade the binary event of the FOMC announcements using a Strangle (on either SPY or TLT), then we need to wait till Friday (or later) to capture profits; closing our position on Wednesday will not work.

If you would like to learn more about options, and how to generate consistent weekly income trading options, go to Options Annex.

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