Trading Game Plan For the FOMC – There Are 3 Possible Scenarios. I Am Bullish – All About Timing

December 18, 2013

It’s all about the Fed today. The price action will be very dull until the statement and then all hell will break loose. It’s important to have a game plan in place ahead of the news.

I am bullish, but I am keeping my size small. This is a low probability trading environment. When the dust settles, I will ramp my size up.

Global economic conditions are improving and the threat of tapering has kept a lid on this rally. Japan continues to ease and business confidence is high. China set a 2014 growth target of 7.5% and that is better than most analysts feared. The EU is rebounding and flash PMI’s were better than expected. Unemployment in the UK fell to a four-year low.

Growth in Europe is the biggest potential catalyst. The ECB is making progress on central bank reform and dismal economic activity has weighed on global markets for the last few years. Credit concerns are low.

Earnings season is over and revenues were flat. However, profits and cash flows are at record levels. Over 6% of daily market activity is related to corporate buybacks (highest ever). Stocks are attractively valued and any uptick in demand will go straight to the bottom line.

The political winds in DC are changing. The Senate will approve the budget today. It is now just a formality. Republicans want to stay out of the headlines and they will extend the debt ceiling without much of a battle in Q2. They feel that Obamacare will implode and they will win the Senate in 2014.

Traders are prepared for the Fed to taper. Interest rates will rise, but that is not going to spoil the rally as long as economic growth improves. Activity has been good enough to compensate for the negative impact of the government shutdown in October.

There are three possible outcomes today. The Fed could taper (20% chance), they could set a target date (60% chance) or they could do nothing (20% chance).

If the Fed tapers, the market will selloff and it will find support in a few days (probably around SPY $175). This news would be a bit of a shocker for the market, but it would be an economic vote of confidence by the Fed. This would be an excellent buying opportunity.

If the Fed sets a target date, the market will be volatile for a few hours, but it should be able to rally after the news. Traders are used to the idea and tapering does not mean tightening. The Fed is likely to reduce bond purchases by $15 billion and they will maintain their zero rate interest policy (ZRIP). In either of these first two scenarios, the Fed might lower the jobless target rate. This would soften the blow and it would keep ZRIP in place for a few years. This inclusion would be very bullish long term.

The final scenario is that the Fed does nothing. On the surface, this would seem to be bullish. Stocks will shoot higher on the news. Unfortunately, this rally won’t last. Traders don’t like uncertainty and we will have to deal with the issue in January. This scenario played out in September and the market quickly reversed after the spike.

I don’t believe the first scenario will happen. Janet Yellen needs to take the reins and set the course. Consequently, I bought some calls ahead of the statement. I am keeping my size small and SPY $178 is my stop. If I get stopped out, the position will take a beating because prices will move quickly. When the dust settles in a few days, a fantastic buying opportunity will present itself.

If the second (and most likely) scenario plays out, I am prepared to take some heat on my calls initially and I will lower my stop to $177.50. I believe the dip will be very short-lived (perhaps only an hour or two). I want to add to my call positions once support is established.

I hope we do not see the third scenario. This would keep a lid on the market and we could see some profit taking into year-end. The market will surge on the news and I will take profits on my call positions once the move is exhausted. I will not buy more calls.

The macro backdrop is very bullish. Once we get this piece of news out-of-the-way, the market should be able to rally.

I am keeping my size small, but I am willing to ramp up once the dust settles. That might take a few days.

You can use this game plan to trade the SPY, but you will find better opportunities in individual stocks. Look for strong trends, a period of consolidation and a breakout through horizontal resistance. Use the breakout as your stop.
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