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The Market’s Overreacting to the Fed Again – Here’s How to Trade It

It was no surprise that the Federal Reserve’s FOMC (Federal Open Market Committee) raised the benchmark fed funds rate by 50 basis points yesterday. (In case you didn’t know, Fed funds are overnight loans big banks make to each other. A “basis point” is one one-hundredth of a percentage point, so 50 basis points is one-half of one percent.)

What looked like a surprise was how the market reacted to the Fed’s announcement.

After a quick move higher, having expected a 50-basis point hike, stocks dropped hard and fast.

Traders and investors seemed to be reacting to other news that also should have been baked in, which was Chairman Powell saying the Fed expects to see the fed funds terminal rate, the highest they want to see it, go to 5.1%, and that they’d likely keep rates up there for all of 2023.

But that wasn’t news. The Fed’s been saying they’d be keeping rates higher for longer for some time, even warning markets they weren’t paying attention to their “higher for longer” messaging. And the fed funds futures market had priced in a potential 5% terminal rate, so that wasn’t a surprise.

So, why did the markets sell off yesterday, and why are they selling off even harder today?

Two reasons: fear and greed, and one player who got caught in the middle.

What you’re seeing is the push-pull between traders and investors betting on both sides of the fence, and a deliberate move by market-maker dealers to cover the losses they incurred by trading with both groups.

It looks bad, I know. But there’s an upside, because those big broker-dealers have done this kind of thing before, and because of that, I know what they’re going to do next.

And if you do what they do, you could make a killing. Here’s how.

This Is How the Market Makers Caused the Selloff

Greedy traders and investors expecting the market to bounce higher off the Fed’s announcement had been buying stocks and call options on benchmark ETFs. They were betting the pop higher would take indexes above important resistance levels, like 4100 for the S&P 500, which would bring in sidelined money and money managers who don’t own enough stocks with the market heading higher.

On the fear side, traders and investors who had seen the market try again and again to get above those resistance levels, only to get there and fall back for the fifth time this year, had been shorting and buying put options. They were betting the Fed announcement would send stocks lower.

The hard-and-fast selloff yesterday and today wasn’t because of the Fed announcement or Powell’s comments. It’s because bulls and bears had been betting by buying huge amounts of call options (in the case of bulls) and huge amounts of put options (in the case of bears). And when I say “huge,” I mean trillions of dollars’ worth of both.

All those options, calls and puts, were sold to all those traders and investors by giant options market-maker broker-dealers like Citadel, Goldman Sachs, and Deutsche Bank Securities, and those dealers moved the market.

As soon as the initial pop higher yesterday was over, and markets turned south, call option buyers saw their potential profits eroding quickly and began selling their call options.

What’s critical to understand is that tomorrow, Friday, December 16, 2022, is a quadruple witching options expiration day. That means most of the options bulls and bears had been buying expire tomorrow. Either they make money if they’re right or lose money if they’re wrong, and the same goes for the dealers that sold all those calls and puts.

For the call option buyers who saw their hoped-for gains quickly disappear, they started selling their call options as soon as they could.

The dealers who had sold them all those call options started buying them back. But far more importantly, those market-maker dealers, who had bought futures as a hedge against the call options they sold, didn’t need those hedges anymore and started selling their futures on indexes like SPX (the index tracking the S&P 500).

At the same time, the same market-maker dealers selling their futures hedges and knocking markets down saw the hundreds of millions of put options they’d sold start to go deeper and deeper “into the money.” When that happened, those dealers took losses, which they had to offset by shorting a lot of futures and knocking the markets even further down. All of this led off Thursday’s trading and greatly exacerbated today’s selling.

So it’s been the dealers selling long futures hedges they no longer needed that pushed the market down, then shorting billions of dollars’ worth of futures to hedge all the put options they’d sold that tanked markets.

With me so far? Good.

What You Need to Do Right Now

Now you need to know that all of this will be over by Friday.

The hard selling of futures by dealers is their hedge against the puts they sold. But they’re still losing money. So, what they’ll try and do is move the markets higher.

Watch what happens tomorrow, Friday morning. Those dealers who are short put options will try and buy futures in the pre-market to make it look like the selloff is over and stocks will bounce Friday.

If they lift futures enough in the pre-market, they could scare those put option owners into selling their puts at the open tomorrow. If they start selling their put options back to the dealers they bought them from, those dealers won’t need their short futures hedges anymore and will start buying to cover their short futures positions. That could lift markets.

In their perfect world, if the market-maker dealers can rally the markets back above all the strike prices of all the put options they sold, they get to keep the premium they sold them for and make a very handsome profit.

That’s the game going on into this expiration.

You can play along by buying call options on the close today that expire tomorrow. If you buy out-of-the-money calls on the SPY, SPX, or QQQs, and if dealers buy back futures and lift the market tomorrow, you could make a quick killing.

It’s a very speculative trade, but what the heck, try it! It’s what the pros are going to try and do.

And after all of it is over, the market’s going to realize what Powell and the Fed did and said was expected, and Mr. Market will go back to doing what it does, which is to trade whichever way the majority of traders are betting.

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