Will the Fed pull the plug on this rally?

Global markets sold off hard in the wake of Fed Chairman Ben Bernanke’s testimony yesterday in which he discussed the possibility of scaling back the amount of quantitative easing sometime within the next few Fed meetings.  Although this comment caused the market to give back much of its gains, it wasn’t until the Fed minutes were released that the market began to roll over. With an almost 40 point swing in E-mini S&P futures from highs to lows it is clear that traders are very much concerned over an end to easing.  The Fed minutes also showed that the hawkish members may be voicing their concerns more loudly and that the pressure to taper the program is increasing. The Fed is clearly split but leaning dovish.

Markets around the world responded sharply to the news with the Nikkei closing down more than 7% after trading higher early in the session. Weak economic data out of China also put pressure on markets. European markets also responded to the weakness and fears that U.S. stimulus may be coming to an end.

So is the most unloved rally of all time finally over? Keep in mind that in addition to the comments Bernanke made on a possible taper in the next few months he also expressed major concerns over what would happen if the Fed tightened monetary policy too early. He spoke of the substantial risks to economic recovery if the easing program is brought to an end too early.

With most of the Fed members still in Bernanke’s corner and the pattern of dip buying this year, many traders may look at this sell-off as an opportunity to buy into this market. What is the most effective way they can do so while still setting up a great risk vs. reward setup?

There are a few products that can be used.

  1. SPX options. These options track spot S&P 500 so they wouldn’t be the most effective hedge for a futures trader.
  2. The ETF. SPY tracks the index very well, but again this is not the most effective hedge on a futures position.
  3. E-mini S&P 500 Futures and Options. This gives a trader the best opportunity to set up a great risk vs. reward trade while tracking the performance of the index very well. This is also one of the most liquid futures markets.

Knowing that options on futures will set up for the best return on initial capital I can now look at a trade setup.  The June at-the-money straddle is implying a range of 49 points by expiration. This gives me an upside target of 1,684.

Trade: Buying the ES 1660-1680 Call Spread for 6.00
Risk: $300 per 1 lot
Reward: $700 per 1 lot
Breakeven: 1666.00

This trade sets up for a great risk vs. reward ration if the E-mini S&P 500 futures trade above 1680 on expiration.

Click to enlarge.

About the Author
James Ramelli

James Ramelli is the Moderator of the Live Futures Options Trading Room at KeeneOnTheMarket.com where he actively trades futures and options on futures while educating members on strategies, setups and risk management. He has a degree in Finance with a focus in Derivatives Trading and Financial Engineering from The University of Illinois and has been trading for five years. James appears regularly on Bloomberg T.V. and BNN and writes a weekly column for Futures Magazine.

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