Executive Summary

With the June FOMC meeting this week, Rich discusses a horizontal spread using E-mini S&P 500 expiries available five days a week.

The June Federal Open Market Committee (FOMC) meeting is this week on Wednesday, June 15. It’s one of the most important days of the summer and not just because it’s my birthday. The market has become conditioned to specific types of responses around FOMC meetings. Some of this may even be coded into the algorithms of certain quantitative strategies. The notion of the positive drift into FOMC meetings was brought to the forefront by no other than the Federal Reserve itself. In 2011 (later revised in 2013), researchers Lucca and Moench found statistically significant excess returns in the equity markets in the run-up to FOMC meetings. These excess returns were not apparent in other assets. Other academic studies have also found this same positive drift. The abstract from the Lucca and Moench paper stated:

We document large average excess returns on U.S. equities in anticipation of monetary policy decisions made at scheduled meetings of the Federal Open Market Committee (FOMC) in the past few decades. These pre-FOMC returns have increased over time and account for sizable fractions of total annual realized stock returns. While other major international equity indices experienced similar pre-FOMC returns, we find no such effect in U.S. Treasury securities and money market futures. Other major U.S. macroeconomic new announcements also do not give rise to pre-announcement excess equity returns. Pre-FOMC returns are higher in periods when the slope of the Treasury yield curve is low, implied equity market volatility is high, and when past pre-FOMC returns have been high. We discuss challenges explaining these returns with standard asset pricing theory.

Source: Lucca, Moench 2013 – Federal Reserve of NY Staff Reports

With forward guidance having become an important tool in the Fed toolkit during and after the Great Financial Crisis in 2008, these meetings don’t often provide a major surprise to the market in terms of the actual rate hike (or cut) announced. In fact, if you look at the CME Fed Watch Tool, you can see that 50 bps point hikes are priced into the Fed Funds future for both the June 15 as well as the July 27 meetings. There is about an 80 percent probability of 50 bps more in the September 21 meeting. This meeting also comes after the Jackson Hole Fed Symposium, which occurs annually at the end of August. Thus, one can assert that the real news of the meeting will not come from the rate change itself, but from the press conference and guidance that comes after the announcement. However, this may not be fully taken into account by the algorithms that are used to the standard positive drift of Fed meetings.

Figure 1: CME Group Fed Watch tool

If we look at the performance of E-mini S&P 500 futures around FOMC meetings this year, the pattern isn’t as clear as the academic studies have suggested. In each of the meetings this year, denoted by the vertical white line in the chart, the E-mini S&P 500 futures have had weak performance heading into the meetings. In January and March, futures responded positively in the days that followed. However, in the May meeting, futures responded negatively in the days that followed. If we think back to at least the last two meetings, the message from the chairman in March was unexpectedly hawkish, as the dot plot raised the terminal Fed Funds rate by 40 bps. Yet, in May, the market interpreted the comments as dovish, because Chairman Powell took 75 bps hikes at meetings off the table. The market reaction in the days that follow may suggest that it's most importantly concerned with inflation, therefore a hawkish FOMC is positive news, but a dovish FOMC may be more concerning.

Figure 2: E-mini S&P 500 futures moves around 2022 FOMC meetings

The particular FOMC meeting in June will be potentially more important than others because we will not only be hearing about future rate hikes, but we will also begin to discuss the magnitude and timing of quantitative tightening, which was scheduled to start on June 1. Researchers Wu and Xia of the Atlanta Federal Reserve have calculated what they refer to as a shadow Fed Funds rate. This rate not only takes rate moves into account, but also the so-called unconventional monetary policy tool of either quantitative easing (QE) or quantitative tightening (QT). I have overlaid the Wu-Xia shadow Fed Funds rate in blue with the year-over-year change in the S&P 500 in green. The shaded areas are the periods when the Fed is embarking on tightenig policy including rate moves and QT. I have also drawn a horizontal line at the zero return level. One can see that S&P returns are not necessarily negative during this entire hiking period even though they may tend to be early in the tightening regime. However, when the market begins to sense we are near or at peak hawkishness, positive returns can come back to the market.

Figure 3: S&P 500 Index moves during previous FOMC hiking cycles

Putting this all together, the stage may be set for a meaningful difference of opinions around the outcome from the FOMC meeting, the forward guidance given, and the reaction of E-mini S&P 500 futures. The positive drift we have historically seen hasn’t occurred in 2022. The reaction after meetings in 2022 has been mixed. Priced into the market is a subtle decrease in the intensity of rate hikes after the July meeting, with anecdotal evidence that some market participants are expecting a dovish pivot by central banks at the Jackson Hole Symposium in August, as the economic data may show at that time a deterioration in conditions. Still, there are many things that can possibly change at the June meeting and traders may have a strong difference of opinions on the outcomes.

A difference of opinions on the direction and magnitude of a market response to an isolated event can be expressed via calendar spreads. Typically, we think of option spreads that expire at the same time but where there are different strikes or puts versus calls. The value of these spreads at expiration depends entirely on the underlying price. Though, if the spread is created by options that expire at different times, the spreads value depends on both the underlying price when the shorter-term option expires, but also on what will happen between the expiration of the short-term option and the longer-term option. Historically, traders could only express this via monthly or even quarterly option expirations. This meant that there was a lot of other drivers that could affect a price of the intervening period. Now CME Group has listed not only weekly option expirations but also daily expirations on E-mini S&P 500 futures. These daily expirations allow a trader to express a far more efficient difference in opinion around a very specific event.

For instance, if we look at the term structure of options expiring just this week, we can see the subtle increase in implied volatility for the options that expire after the FOMC meeting versus options that expire before the June 15 meeting.

Figure 4: E-mini S&P 500 (ES) Volatility Term Structure

In fact, CME Group and QuikStrike has a forward implied volatility calculator that can take the difference in implied volatility from different contracts and tell us what the expected move on a given day would be. Using that tool, we calculate the implied one day move. We can see the forward implied volatility for the event, the increment increase in volatility above the standard volatility, is 7.13 percent – it is an annualized number. If we take the one day move from that, we need to take the square root of 252 because that is how many trading days there are. This is about 15.9. That suggests a move in the market just because of the FOMC meeting of about 45 bps in either direction. This is the 15.5 points we see in the pink and green at the top. If we just refer to Figure 2 above, we can ascertain that perhaps 15 points is not that large. Particularly for a meeting that many may think has even more potential consequence than other meetings. Said another way, this may be volatility a trader wants to buy.

Figure 5: Event Volatility Calculator

A trader may want to express an opinion on what may appear to be subdued volatility priced into the FOMC event this week. However, despite other economic events, the trader may also feel the reaction ahead of the FOMC meeting will be muted. As I tell the students in my derivatives class, theta can be the enemy of the option trader. You must pay theta or time decay every single day (including weekends). This does not mean the market will move on all those days. Yes, we see the academic work on the drift. A volatility buyer wants a lot of movement, though, and not just a drift. Thus, the trader may want to reduce their theta exposure.

One way to get around that is by selling the same strike and option for the day before the event as the one you buy for after the event. For instance, if one’s view is that the FOMC will not be as dovish as the market may be anticipating in terms of forward guidance, empirically we have seen a positive market response to this hawkishness as it reigns in inflation expectations and can prove to stabilize the longer-term interest rates. This potentially has a positive impact on equities via both the forward multiple but also on the expected margins. Buying a call that expires after the FOMC meeting might seem too expensive to a trader; however, if the trader sells the same call for the Tuesday before the meeting, that trader can potentially hedge these other events and drift in the days leading up to the meeting and isolate specifically on the expected move and subdued volatility priced into the meeting itself.

In this example, I have sold the Tuesday E-mini S&P 4125 calls and have purchased the Friday E-mini S&P 4125 calls. I am building this example on Wednesday June 8 as an example. The pricing will be different when you read this. However, this can show you what an idea might look like the week before an event.

I have sold an option with five trading days until expiration and bought an option with nine trading days until expiration. You can see on its own, I would have had to pay 59 points for the Friday option outright. This is a much more expensive breakeven. However, by having the view that not much will happen before the FOMC, I can take in almost 45 points to defray the cost, leaving me with a spread cost of a little over 14 points. This roughly compares to the event volatility calculation of 15.5 points (there was decay even while writing this).

I am selling a 23.5 implied volatility and buying a 23.8 implied volatility. A slight premium, which leads to that event calculation above. However, the trader may believe that all the volatility in the next week or so will come from this June 15 meeting. The Greeks on this spread before the meeting are essentially zero. All of a trader’s eggs are in the FOMC basket.

Figure 6: Tuesday-Friday E-mini S&P 500 spread

Of course, there are risks to calendar spreads. We could move a great deal before the event and then not at all after the event. We may move so much before the event to the downside that our call options don’t come into play. In both cases, the extra premium a trader may pay wouldn’t have been worth it. However, the idea I lay out fits with a view that all of the movement comes from the event.

The new daily expirations available at CME Group provide traders with the opportunity to truly customize their spreads and isolate their risk to the specific event they are looking to capture. There is open-ended risk around the event, as there always would be with a calendar spread. Yet, in a world where there are so many other potential drivers to market moves, the flexibility and ability to isolate on a specific event is an incredibly powerful tool in a trader’s toolkit.

These options are relatively new (Tuesdays and Thursdays that is) however, we can see from the data that there is already a good amount of interest. For sure, the Friday weekly options still dominate the volume. These new Tuesday and Thursday option expiries (in orange and yellow) are currently the smallest contributors to the pie, however they are growing rapidly since launch. With the functionality the daily expirations provide a trader to customize their view, and the ability to use CME and QuikStrike tools to quickly calculate what is priced into that event, we may see the volume in these daily options become a growing part of the market.

Figure 7: ES Weekly Option Volume

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