The decisions of the Federal Reserve can create ripple effects through financial markets, including the options market. Because of the Fed’s impact on options trading, investors should pay close attention to the Federal Reserve. The goal of this guide is to help traders understand and navigate the Fed’s impact on options pricing. Let’s get into decoding the Fed’s effect on options markets and how options traders can successfully maneuver around their decisions.
The Federal Reserve—A Quick Overview
The central bank of the United States is known as the Federal Reserve or the Fed. It was formed by Congress in 1913 to create a monetary system capable of responding to major stresses of the banking system. Its primary role is to stabilize the US economy and financial system. The structure of the Fed consists of a Board of Governors, the Federal Open Market Committee, the Federal Advisory Council, and twelve Federal Reserve Banks around the country.
Let’s highlight some of the Federal Reserve’s primary roles in the U.S. economy:
- Setting Interest Rates: The Fed is responsible for controlling the cost of borrowing within the banking system. The Fed has a target interest rate (federal funds rate) that they shoot for, which dictates the rate at which banks charge each other for overnight lending. The target interest rate is attained by the Fed buying or selling government bonds which affects the economy’s interest rates and influences the money supply. Raising the rate is intended to fight inflation or cool down an overheated economy, while lowering the rate can encourage growth when there’s an economic recession.
- Managing Monetary Policy: The Fed uses tools like quantitative easing and tapering to promote stable prices, encourage maximum employment, and maintain moderate long-term interest rates. Tools for managing monetary policy include open market operations, discount rates, interest on reserve balances, and reserve requirements.
- Providing Financial Services: The Fed operates payment systems such as interbank transfers and check clearing services. They also act as a fiscal agent for the federal government by having federal receipts and payments flowing through the Fed’s Treasury accounts.
- Protecting Consumers: To ensure financial institutions comply with laws and regulations, the Fed performs on-site examinations and inspections. They also identify and investigate possible violations of consumer protection laws by reviewing customer complaints and consumer inquiry programs.
- Promoting Community Development: The Fed supports research efforts that aid community developers and policymakers to improve the economy and well-being of communities. They also interact with communities to understand potential challenges and opportunities in communities for economic development.
Key Actions of the Federal Reserve and Their Market Implications
What are the consequences of the Fed’s actions on the market, particularly the consumer and the price of trading options? We’ll highlight what occurs when interest rate cuts or hikes are introduced, how quantitative easing and tightening work, and the role of economic indicators like inflation or employment data shape the Fed’s monetary policies.
Interest Rate Decisions
Interest rate decisions on the part of the Fed ultimately affect market sentiment among consumers and options pricing. Interest rate hikes or cuts can create ripple effects on aspects of options trading like equities, bond markets, and volatility.
- Interest Rate Hikes: Hikes are introduced by the Fed when attempting to control inflation or to cool down an overheated economy. Rate hikes generally lead to negative market sentiment. It causes stock prices to fall in value and it leads to pricier call options which means it costs more to trade options. Rate hikes lead consumers to tighten spending—they generally slow down economic activity, which is the intent of their introduction.
- Interest Rate Cuts: Interest rate cuts are introduced when the Fed is trying to stimulate economic activity during periods of economic downturn like a recession.
Quantitative Easing and Tightening
Quantitative easing is a monetary policy where the Fed purchases financial assets to stimulate economic activity and increase the money supply. It ultimately results in an increase in liquidity, which means that investors can buy and sell securities quickly. It injects more money into the economy and makes it easier for banks to lend. Quantitative easing also leads to more borrowing and investors with consumers. The demand for options goes up because the cost of trading is much better under quantitative easing.
On the other hand, quantitative tightening is another Fed monetary policy that aims at reducing liquidity in an economy. It has the opposite effect on the market and investors. Tightening makes it more difficult to buy and sell securities quickly. Banks will have a more difficult time lending money and it ultimately reduces borrowing and investing in the market. The demand for options goes down because the cost of trading goes up.
Inflation Announcements and Employment Data
The role of economic indicators is key in shaping Fed policy. A few examples of economic indicators are inflation announcements and employment data. If inflation is on the rise, the Fed will typically take the action of hiking interest rates to fight inflation. When inflation is too low, the Fed will lower interest rates to stimulate the economy. Following these adjustments, it’s common for the Federal Reserve to look at employment data to determine if their current monetary policy is working. They can continue to make adjustments as they monitor this data closely.
With the Fed keeping a close eye on employment data like job reports, it’s a good idea for options traders to monitor CPI reports and jobs data to anticipate coming monetary policy from the Fed. A bad jobs report usually results in the Fed dropping interest rates which leads to better options pricing and increased liquidity. This makes things more favorable for traders in general. A good jobs report, though, might signal a coming interest rate hike, leading to less favorable options pricing.
The Fed’s Influence on Volatility
There is a strong link between Fed announcements and the volatility index (VIX). When investors or traders catch wind of the Fed getting ready for a policy announcement or releasing a job report, volatility tends to spike. It doesn’t matter if the Fed is taking measures to cut or raise interest rates; it’s usually met with increased volatility in the stock, options, or bond markets due to uncertainty.
There are several strategies for options traders during periods of heightened volatility or when the market conditions are relatively stable, including the following:
- Long Puts: This strategy involves paying money for the right to sell the stock at a certain strike price in the future. The hope is that the stock will move lower than the current trading price because the investor believes that the stock price will decline over the lifetime of the contract. The long put increases in value when volatility is on the rise. Investors can make substantial profits, and losses are limited to only the premium paid.
- Shorting Calls: Also called an uncovered call, a naked call, or a bear call, investors use this strategy by selling a call contract at the strike price, which is usually at or above the stock’s current market price. Shoring calls can be used when the investor believes the price of the underlying security will fall or stay stable. They can benefit from the premiums that get from selling the call and having it expire as worthless.
- Shorting Straddles: This technique involves one short call and one short put. Each one has the same underlying stock, strike price, and expiration date. The idea is that the investors don’t expect the underlying asset to move considerably higher or lower during the life of the contract. It’s expected to stay within a narrow range.
- Shorting Strangles: A short strangle involves the investor simultaneously selling an out-of-the-money put and an out-of-the-money call. It’s best used when you expect the underlying asset’s price to remain stable and within a specific range. If investors believe volatility will be low, they can use a short strangle to profit from time decay from the options they sell. They’re best used in sideways markets.
- Ratio Writing: This option strategy can be used by traders or investors who own shares in an underlying stock and sell more call options than the total number of shares owned. Traders can earn additional premiums that are received by options sales. They’re best used to increase covered call profits.
- Iron Condors: The iron condor technique involves buying and selling options to profit from the relative stability of an underlying asset. It’s made of four options contracts with different exercise prices, but the same expiration date. Iron condors involve buying two out-of-the-money options and selling two options that are closer to the money. An iron condor’s maximum profit is the premium paid, and the maximum loss is limited to the difference between the two strike prices involved.
Options Pricing and the Fed
Let’s take a deeper dive into the Fed’s decisions and how they affect options pricing. Keep reading to learn about what drives implied volatility changes during Fed meeting cycles, how uncertainty can stall or accelerate time decay, and the correlations between Fed-driven equity moves and options pricing.
Implied Volatility (IV)
Implied volatility is a forward-looking measure of market expectation, basically how much the price of an asset is expected to fluctuate in the future. Implied volatility or IV tends to go up during major economic events like the release of GDP reports or central bank announcements where the Fed outlines new plans to deal with a growing or contracting economy. Implied volatility usually spikes going into these Fed meeting cycles which results in a significant increase in options prices. Options are more expensive to purchase but IV spikes are great for buyers who can collect higher premiums on all options of the underlying security (calls and puts).
Time Decay (Theta)
Time decay is the natural reduction in an option’s price as it gets closer to its expiration date. The general rule of thumb is that time decay increases as an option’s probability of expiring out-of-the-money increases. The ultimate impact of interest rate changes is greater with longer-term options because of the sensitivity of an option price to changes in the interest rate (the “Rho” Greek). On the other hand, shorter options benefit from time decay because they are more advantageous for short-term option sellers (who profit from time decay as a trading strategy).
Underlying Asset Movements
Implied volatility tends to rise and negatively affect options pricing when the Fed makes moves that have an impact on the equity market. The rise of implied volatility in the underlying stock usually leads to higher option premiums, which can be advantageous for investors who are looking to generate additional income through premiums made on sales.
When the market isn’t looking to change all that much and implied volatility is expected to be low, it’s the exact opposite—premiums drop but the price of buying or selling options is more favorable. The market is much more liquid when volatility is low, and the market is experiencing stable conditions.
Strategies to Trade Options Around Fed Events
The right strategy for trading options around Fed events all depends on what is happening before and after the announcement. We’ll highlight the appropriate techniques and approaches to trading options around these events and announcements and we’ll also address some helpful long-term strategies that can be used to incorporate macroeconomic trends into options portfolios.
Before the Announcement
The best move that investors can make in the days or weeks leading up to one of the Fed’s announcements is to use straddles or strangles to capitalize on anticipated volatility. Use these hedging techniques to minimize risk:
- Long Straddles: This technique is ideal before a Fed announcement as investors are expecting to experience a significant price move or market volatility. They might be unsure if the price will move up or down, but they are certain that there’s going to be a significant shift of some kind. Investors must buy a call and a put option for the same underlying asset. Long straddles involve having the call and put set for the same expiration date and strike price.
- Long Strangles: This one involves one long call with a higher strike price and one long put with a lower strike price. The success of this strategy depends on the underlying stock’s price either falling or rising by a considerable amount. Because the stock price has no upper limit on how high it can rise, the maximum profit of long strangles is technically unlimited because the profit potential on the upside is limitless. The maximum loss on this strategy is the total premium paid for the call and put option.
After the Announcement
Once the Fed has made an announcement one way or another on interest rate hikes or cuts, it’s key for options traders to adjust positions based on the market reaction.
If there was a rate cut, it might be preferable to invest in:
- Growth Stocks—A share in a company that is expected to grow faster than the stock market as a whole, best for a bullish market.
- High-Yield Bonds—A great option following a Fed rate cut, high-yield bonds are corporate bonds that have a higher interest rate than other bonds because they have a higher risk of default.
- Real Estate Investment Trusts—Rate cuts lead to easier investing, so getting in on real estate investment trusts (REITs) might be a good option. These are companies that own, operate, or finance income-producing real estate. Investors can earn income from real estate without having to buy it!
- Preferred Stocks—Combining characteristics of stocks and bonds, this security offers investors a predictable income stream through dividends and also represents ownership in a company. These investments are known for being ideal following a Fed rate cut.
- Dividend-Paying Stocks—These are a percentage of a company’s earnings that are paid to the shareholders as their share of the profits. Dividend investors can expect a boost as interest rates fall.
If there was a rate hike, it might be preferable to take the following actions:
- Adopt New Borrowing Approaches: Refinance existing debts, maintain a healthy credit score while managing outstanding balances wisely, and continue to explore fixed-rate and adjustable-rate loans.
- Proper Asset Allocation and Diversification: This includes balancing fixed-income investment with equities, investing in alternative assets, and investing in international markets for additional diversification.
- Hedging Against Interest Rate Risks: Invest in inflation-linked bonds like Treasury Inflation-Protected Securities and use interest rate swaps to your advantage.
- High-Yield Savings Accounts and Short-Term Bonds: Focus on certificates of deposit or short-term bonds, plus savings accounts with high yields where there are competitive interest rates.
- Properly Monitor Your Cash Flow: Create and maintain a healthy investment budget, reduce your non-essential expenses, and begin to build emergency funds as a contingency plan.
- Tax-Efficient Investing: Fully fund IRAs or 401(k)s you might have, invest in tax-free municipal bonds, and use tax-loss harvesting techniques to offset taxable gains in your portfolio.
- Manage Debt and Focus on Fixed-Rate Mortgages: Take care of any outstanding credit card balances and focus on fixed-rate mortgages if you’re considering buying a home or refinancing your existing home.
Long-Term Strategies
Leveraging LEAPS (Long-Term Equity Anticipation Securities) in response to policy trends can be a useful long-term strategy for riding out a prolonged macroeconomic trend. LEAPS are publicly traded options contracts with expiration dates that are a year or more going all the way up to three years. They grant the buyer the right to buy or sell the underlying asset at a predetermined price before the expiration date hits. LEAP is ideal for traders who want to trade based on a prolonged trend, in this case, a policy change.
Case Studies—The Fed’s Impact on Options Markets
This section of our guide will highlight key moments when Fed decisions dramatically moved options markets. To make our point about interest rate hikes and cuts, we’ll be focusing on the rate hike cycle that occurred in 2018 and 2019 as well as the rate cuts and quantitative easing that was used in response to COVID-19 in 2020.
Example 1—Rate Hike Cycle (2018-2019)
Three interest rate hikes occurred in 2018 alone (March, June, and December) with the Feds citing they were trying to prevent a tight job market from causing excessive inflation.
These three rate hikes affected the options market where call options increased in value and put options decreased in value. This is all due to the “rho” effect. Because 2018 was a year where the cost of borrowing money went up, it became preferable for investors to exercise put options (the right to sell) instead of exercising call options (the right to buy).
Example 2—Quantitative Easing During COVID-19 (2020)
When COVID-19 hit in March 2020, the Fed expanded its repurchase program. They bought assets and sold them back at a later date for $1.5 trillion. The Fed also added an extra $500 billion four days later to make sure the money markets had enough liquidity. In addition to quantitative easing, the Fed also cut rates to a low range of 0-0.25% which increased the value of put options but decreased the value of call options.
During COVID-19, it was much easier to buy options at a good price than it was to sell them. Because the markets were so volatile during that period, buying put options during the ensuing economic downturn was a viable alternative to selling stocks.
Tools and Resources for Monitoring the Fed
To stay informed and properly monitor the Fed to stay abreast of any changes that might be coming for the options market, we recommend using the following tools and resources so that you’re well prepared for what might be coming your way. It’s not a guarantee for insulating you against losses, but it will help to keep you on the winning side of the curve more often than not.
Federal Reserve Meeting Schedules
The Federal Reserve makes no secret of when they meet throughout the year. You can access their annual meeting schedule online. Once you’re aware of when big announcements are slated, you know when implied volatility is expected to increase throughout the year. This allows investors to use the appropriate options trading strategies to take advantage of the market volatility that comes around the time of these meetings.
Websites and Tools for Economic Data
Investors can use websites and tools that present economic data for monitoring the Fed throughout the year.
FRED: This stands for Federal Reserve Economic Data and it’s a place where traders and investors can download, graph, and track over 825,000 economic time series from about 115 sources. It contains frequently updated US macro and regional economic time series at annual, quarterly, monthly, weekly, and daily frequencies.
Bloomberg: Check out Bloomberg Surveillance which covers the latest in finance, investments, and economics around the world. There’s a cable TV show, podcast, newsletter, and YouTube channel available, allowing traders and investors to keep a close eye on the market and monitor any major moves by the Federal Reserve.
Real-Time Market Analysis Platforms
You can also check out independent platforms that analyze the market while offering real-time data and updates to their users. A few examples of these businesses include TradingView, Tableau, Whatagraph, Amazon QuickSight, Stock Rover, Google Trends, and Mixpanel. Investors can access a continuous flow of information on financial instruments as market events unfold. Use these platforms to monitor instruments like bonds, stocks, options, indices, and commodities.
Navigate the Fed Like a Pro
The Federal Reserve is responsible for setting interest rates, managing monetary policy, protecting consumers, promoting community development, providing financial services, and a host of other obligations. More relevant to options traders, the Fed plays a key role in maintaining the US economy, but their decisions can have a drastic effect on the options markets, both good and bad.
Don’t be caught off guard when the Fed introduces an interest rate hike or cut. Take what you’ve learned from this guide to better navigate future Fed-driven market movements. Remember that interest rate cuts make it easier to buy options at a good price, and interest rate hikes make it easier to make money selling options.
If you’re looking to explore more trading strategies or need extra resources about this topic and others, be sure to find more at OptionsTrading.org.
Frequently Asked Questions
What kind of questions have our customers and readers been asking about the Federal Reserve and how their decisions impact options pricing? We’ve taken the three most common questions we got on the subject and answered them below for your convenience—get the key takeaways of our guide right here.
Why Does the Federal Reserve Affect Options Prices?
The Federal Reserve directly influences interest rates. This is a key aspect when calculating the value of options premiums. When the Fed raises interest rates to deal with inflation or attempts to cool down an overactive economy, it makes the price of borrowing money higher which leads to a higher price of trading options. Fewer people are buying, and more are selling. Interest rate hikes lead to a seller’s market. When there’s an interest rate cut to stimulate the economy, it’s a buyer’s market because the cost of borrowing money is better. It’s less preferable to sell during these times.
What Is the VIX, and How Is It Related to Fed Decisions?
VIX stands for implied volatility, which is a forward-looking measure of market expectation. It’s how much the price of an asset is expected to fluctuate in the future. VIX goes up during economic events such as central bank announcements and it tends to spike before the big meeting. It results in an option price increase—they are more expensive to purchase. However, the spikes are great for collecting higher premiums on all options of the underlying security ( for both calls and puts).
Are There Specific Fed Announcements That Are More Impactful for Options Traders?
One of the biggest events of the year when it comes to the Fed and options trading is the Federal Open Market Committee because this body uses a trio of policy tools to raise or lower the federal fund rate in the United States. It’s key to determine if the FOMC announcement is bullish or bearish which can help inform investors strategy once the announcement has passed.
