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Trading the Pre-FOMC Announcement Drift

March 20, 2019 13:00

Economic events calendar

Source: Economic Events Calendar March 20, 2019 - Admiral Markets' Forex Calendar

The first Fed live rate decision of 2019 is scheduled for tonight at 18:00 GMT, This, combined with Fed chairman Powell's press conference, can have a significant impact on currency pairs containing the USD, along with US stock indices and shares.

While the Fed has taken care to eliminate any rate hike speculation, following the increased volatility of Q4 2018, it is also testing the waters for increased flexibility when approaching the balance sheet, calling the approach "equity-friendly".

So how can traders position themselves to profit from an equity-friendly Fed?

The Pre-FOMC Announcement Drift

One such position to take is the Pre-FOMC Announcement Drift, a strategy for taking advantage of the period before the announcement where volatility tends to spike.

What happens in the lead-up to the FOMC announcement? Records show that when the US yield curve flattens out and indicators point to high volatility in US equities, the 24 hours prior to an FOMC announcement can be traded very profitably.

In fact, nearly 80% of all S&P500 profits 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 could have earned around 80% of the income of a buy-and-hold investor, but at a much lower risk because investment is limited to only eight days a year.

What is particularly interesting is that it doesn't matter if the Fed elects to raise or cut interest rates. The actual interest rate decision itself brought no overall return, the effect performance-wise was zero in total. Instead, the anticipation of an equity markets-friendly decision is of more importance to the trader than the outcome.

How does such a simple strategy work so well?

First of all, the reason lies in the fact that during the week leading up to the Fed decision there is a so-called "blackout period". This means that voting FOMC members are not allowed to give any statements, interviews, or speeches, and this usually results in a drop in trading volume and likewise, liquidity thins out, putting it below average.

Secondly, professional investors usually have a risk-overweight in their portfolio. Before such an event like a Fed rate decision, which can very easily introduce market volatility, these traders tend to reduce any risk exposure and choose to rebuild it after the rate decision. Thus, 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 a drift upwards in equity markets.

How to Trade The Pre-FOMC Announcement Drift

But now the interesting question: how do we implement this strategy?

We want to use the following plan:

  1. We enter a long position in the SP500 CFD on Tuesday, March 19, 2019, at 20:00 CET.

  2. A big disadvantage is that the strategy usually works without a stop loss. Since working with no clearly-defined risk isn't an option for us, 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 ~27 points while the average daily trading range of the last 10 trading days has been 30 points.
    • Therefore, our worst case stop should be in the range between 40 to 50 points from our entry point.
  1. We exit the Long position in the SP500 CFD on Wednesday, March 20, 2019 at 19:55 CET.

SP500 index hourly chart

Source: Admiral Markets MT5 with MT5-SE Add-on SP500 CFD Hourly chart (between February 28 to March 14, 2019). Accessed: March 14, 2019, at 12:00pm 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%.

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