Trading the Fed rate decision’s seasonal event with the SP500 CFD
Source: Economic Events Calendar May 1, 2019 - Admiral Markets' Forex Calendar
On Wednesday, May 1, the Fed's rate decision for 2019 took place. Here, Fed chairman Powell emphasized thay they don't see a case for shifting the Fed's monetary policy 'in either direction', meaning they're not currently considering neither hikes nor cuts in interest rates.
With that in mind, and the knowledge that we saw a rate-cut probability of 60% from the Fed through December 2019, we could come to the conclusion that there is probably still too much dovishness priced into the extant Fed policy, which could result in upcoming USD bullishness and Gold weakness.
While this may be of interest for analysts, our question as traders is: could we have somehow profited from the Fed statement, in either direction?
The Pre-FOMC Announcement Drift
The answer is yes! In fact, several studies show that a strategy called the 'Pre-FOMC Announcement Drift' has been successful since 1980, and the profitability has even improved over the last few years.
In specific, when the US yield curve flattens out (right now, the 2-10-year US yield curve finds itself in the region around its flattest levels since 2007), and the volatility in US equities is relatively high (measured via the VIX), the 24 hours prior to the FOMC announcement could have been very profitably traded.
On average, nearly 80% of all profits from the S&P500 were made within the eight days leading up to the interest rate decision.
In other words: if you bought the S&P500 just 24 hours before the FOMC announcement, you would have earned around 80% of the income of a buy-and-hold investor, but at a much lower risk because you invest only 8 days a year.
What is particularly interesting, is that it didn't matter if the Fed has raised or cut interest rates. The actual interest rate decision brought no overall return. There was zero effect performance-wise. It seems as if the anticipation of an equity-markets-friendly decision of the Fed was of higher importance.
Why does such a simple strategy work so well?
First of all, the reason seems to be in the fact that during the week before the Fed decision, there is a so-called 'blackout period.' This means that voting FOMC members are not allowed to make any statements or give interviews or speeches, either of which usually results in a drop in trading volume and a thinning out of liquidity, putting it below average.
Secondly, professional investors usually have risk-overweight in their portfolio. Before such a risk-prone event like a Fed rate decision, these market participants tend to reduce their risk exposure, rebuild it after the rate decision. So, once the 'blackout period' begins, they reduce their engagements, and instead buy insurance for their portfolios via futures and options. Due to the low liquidity in the markets during that period, small purchases of equities result in an upward drift.
How to Trade The Pre-FOMC Announcement Drift
But now the interesting question: how could we have traded this?
We would have used the following plan:
- We entered a long position in the SP500 CFD on Tuesday, April 30, 2019, at 20:00 CET at 2,944 points.
- A big disadvantage of the strategy is that it usually works without a stop loss. Since working with no clearly defined risk is not an option for us as professional traders, we want to work with a worst-case stop based on volatility.
Therefore, we look at the daily chart in the SP500 CFD, the indicator ATR(14) and at the average daily trading range of the last 10 trading days.
The Daily ATR(14) reads ~20 points while the average daily trading range of the last 10 trading days has been ~21 points.
Therefore, our worst case stop should be in the range between 20 to 25 points from our entry point and was placed at 2,920 points.
- We exited the Long position in the SP500 CFD on Wednesday, May 1, 2019, at 19:55 CET at 2,948 points for a profit of 4 points.
Source: Admiral Markets MT5 with MT5-SE Add-on SP500 CFD daily chart (between February 12, 2018, to May 15, 2019). Accessed: May 15, 2019, at 09:30am GMT - Please note: Past performance is not a reliable indicator of future results, or future performance.
In 2014, the value of the SP500 CFD increased by 11.39%, in 2015, it fell by -0.73%, in 2016, it increased by 9.54%, in 2017, it increased by 19.42%, in 2018, it fell by -6.24%, meaning that after five years, it was up by 36.8%.
Check out Admiral Markets' most competitive conditions on the DAX30 CFD and start trading on the DAX30 CFD with a low 0.8 point spread offering during the main Xetra trading hours. To test Admiral Markets DAX offering in combination with the described strategy above register for a free demo account today and experience the live market risk free!
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