The Fed surprised the market on Wednesday when it announced that there would be no change to its $85 billion per month stimulus program. Markets were expecting a taper of the program in the neighborhood of $10-$15 billion per month and responded to the decision by moving sharply higher. The Dow and S&P 500 (CME:SPU13) touched new all-time highs while Treasury yields saw one of the largest drops in the past five years. The U.S. dollar (NYBOT:DXZ13) also fell sharply against major currencies. Metals markets also saw one of their best days in recent years with gold prices soaring on the release of the statement. Treasury bond markets opened the day with one of the highest short interest rates of all time as markets positioned for the announcement of the taper. Markets got this one wrong and shorts were squeezed out as the market ripped higher. A lot of traders who were short took losses and could continue to do so. The question on everyone’s mind is what to do next. Does the continuation of QE at its current levels mean markets will continue to make new highs, or are concerns over upcoming fiscal policy decisions enough to derail the market?
Remember that there are a few points of uncertainty on the horizon. The main concern for markets in the near term is going to be the debt ceiling. Members of congress are already digging in for another long fight over the issue. Many believe that the uncertainty around the debt ceiling and the possibility of a U.S. default could send markets spiraling out of control. However, in his press conference yesterday, Fed Chairman Ben Bernanke stated that the Fed would have to consider taking action to stabilize markets if debt ceiling concerns cause a panic sell off. Although he was not specific as to what measures the Fed could deploy, it was clear that they would be ready to take action. With Bernanke assuring markets that the Fed will not exit before the economy grows stronger and pledging further support should things get worse, it seems like for now the path of least resistance for markets is up.
So how does a trader take advantage of this?
- Buy Individual stocks in the S&P 500. This is a very capital intensive way to take a view on the index. It does, however, offer the opportunity to leg out laggards and add to winners, but this strategy may not track the index perfectly.
- Buy the ETF. The SPDR S&P 500 ETF Trust (SPY). Although this also would be capital intensive, this is an easy position to manage.
- 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.
Using options on E-mini S&P 500 futures gives a trader the best leverage and can provide them with a great reward-to-risk ratio. Using the November at-the-money straddle, a trader can calculate an upside target and use it to center an options strategy. With December E-mini S&P 500 Futures trading around 1720.00 a trader can use the price of the 1720 straddle, which is trading at 68.25, to calculate an upside target of 1788.25. With that target a strategy can be set up to give a trader a great return potential on their invested capital.
Trade: Buying the ES Nov 1760-1780 Call Spread for 6.00
Risk: $300 per 1 lot
Reward: $700 per 1 lot
This trade sets up for a better than 2-to-1 return on invested capital with a more conservative target than the market is implying.