Options Market Reaction To Fed Interest Rate Hike

The market is trading higher by 1.2% this afternoon having tested recent lows yesterday morning. The rally of yesterday afternoon and this morning has coincided with oil stabilizing and today trading higher. Unfortunately, I expect the major indexes will continue to take their cues from the price of oil in the days to come.

This morning, subscribers to my Cabot Options Trader and Cabot Options Trader Pro advisories and I sold half of our Microsoft March 55 Calls for a profit of 33% in under 24 hours. While I like the chart, order flow and strength of MSFT, none of this will matter if the market unwinds again this afternoon or tomorrow. Because of the recent volatility, I felt it was prudent to take profits on half of the position and go for greater upside with the remainder.

Tomorrow the Fed is expected to raise interest rates for the first time in many years. What the market will do in reaction is literally anyone's guess. That said, I can use the options market to price-in expected moves and risks.

The options market is pricing-in a S&P 500 move of approximately 1.50%-2.00% between today and Friday's close. That seems in line with what I'd expect in light of the recent market volatility and the "biggest Fed day ever" tomorrow.  

The VIX ("the fear index") is trading just above 20--exactly as I had predicted in my Monday morning update. As I essentially said, regardless of how much the market rebounds, the VIX will not likely fall much below 20 before the Fed event on Wednesday. However, once the event passes--if the market does not fall apart--I expect the VIX to trade back in the 15 to 17 range.

Skew, which is the options market fear of large upside or downside moves is pricing-in considerable downside concerns this week. Again, this is what I'd expect after last week's 3.5% slide in the major indexes. Here is the graph of skew of options that expire this Friday. The left side of the graph is downside puts, and the right side is upside calls.

skew chart  
As the graph shows, traders are much more fearful of downside than upside. While that's typically the case because most traders are long stocks and own puts to hedge, this graph is showing extreme fear.

My scanner has been fairly quiet today, which you'd expect ahead of tomorrow's event. However, one trend I see is the buying of upside bank/brokerage calls. Here are a couple of trades of note in those sectors:

Buyer of 30,000 Bank of America (BAC) December 17.5 Calls (exp. 12/24) for $0.30

Buyer of 8,000 E*Trade (ETFC) January 30 Calls for $1.08

It seems likely these trades are pure Federal Reserve-hiking-interest-rate plays because the banks and brokers are likely to be the greatest beneficiaries of a rising rate environment.

Tomorrow's Fed announcement and the press conference that follows may set the tone for the rest of the year. My opinion on how the market will react is as worthless, but I do recommend that you have your watch list ready just in case the market overreacts to tomorrow's event.

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