Option Trading Strategy: Short-Term FOMC Rally Sets Up Long-Term Short.

June 25, 2008
Author: Peter Stolcers, Founder of OneOption

All eyes are clearly on the Fed at this juncture. The market is oversold and today we are witnessing a short covering bounce. Stocks (like regional banks) are leading the way higher. Conversely, strong stocks (commodity stocks) are pulling back. Second quarter window dressing and position squaring ahead of the decision are causing this rotation. On a short-term basis, I believe we will rally. The Fed does not want to create chaos and it has a tendency to give the market what it wants. A rate hike is not expected today and we won't see one. However, a 100% likelihood of a .25% rate hike has been priced into the August bonds. Today's language will prepare the market for a rate hike in August. The Fed will reiterate that the focus is clearly on inflation, not the economy. Rightfully, Bernanke has been blamed for not communicating well with the investment community and I sense that he is trying to change that. In the back of their minds, they have to be concerned that another huge round of mortgage resets is taking place right now. Higher interest rates will force more people into foreclosure. Holding off on a rate hike for another month or two could make a big difference to homeowners as they try to lock in fixed rates (up 33 basis points on a 30-year fixed in the last two weeks). The Fed just threw the kitchen sink at the financial crisis and I don't think they are overly anxious to start raising rates. I believe that we will see a rally after the announcement. SPY 132 is a significant horizontal support level. It represents the March 2007 and August 2007 lows. In April, we saw two large up gaps from this level as buyers stepped in. Today, I am feeling that "bid" comeback. Stocks that have been beaten down the most will fare the best as short covering kicks in. Lower interest rates are good for the banks because they are able to keep their lending spread wide. Unfortunately, consumers have not benefited from the Fed’s rate cuts. Banks have increased their risk premiums and interest rates are as high as they were before the Fed took action. Once this rally (provided there is one)loses its momentum, it will be time to short the market. Global interest rates are headed higher and foreign central banks are tightening. The "soft landing" theory is predicated on overseas growth. Those markets have rolled over and I am not seeing the strength to carry us out of this recession. Higher unemployment, inflation (rising interest rates) and high debt levels signal trouble ahead. It's not often that you can spot a technical formation on a 5-year chart. When you see one, it needs to be respected. The head and shoulders formation tells me that we have seen a peak. If we get a rally, it might be tradable for a few days. Be nimble and take profits. As we approach SPY 138, the headwinds will blow and I expect that resistance level to hold. I will be looking to short the rally on a longer term basis. Regional banks, casinos, hotels, airlines, aerospace, defense, and retail are some of my favorite plays. If the market tanks on the news, I will simply hold my short OTM calls spreads. If they get cheap enough, I will buy them back in. I don’t want to sell into the decline since I think the market is short term oversold. image

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