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How to Trade the Fed Reversal Pattern

By Jeff Clark
Tuesday, August 8, 2006

There’s a big difference between gambling and speculating.
Gambling is a recipe for disaster, as the odds always favor the house. Speculating, on the other hand, is reasonable as long as the odds are on your side.
Trading the market ahead of an FOMC meeting is always a tough gamble. But today it’s doubly so...
Not only do speculators have to guess whether or not the Fed will raise interest rates, but also they need to predict how the market will react to the Fed’s decision.
Currently, the Fed Funds futures market places the odds of another rate hike at about 40%. That’s as close to even money as we’ve seen in several months.
But the real bet should be on whether the market will rally or fall on the rate announcement. And there’s just no way to calculate those odds.
Bulls will argue that another rate hike will prove the Fed is committed in its battle against inflation. They’ll also argue that a pause will signal the end of the tightening cycle and usher investors back into stocks.
In other words, it’s bullish either way.
Bears argue another rate hike will contract the economy even further and lead to a recession. They’ll also argue that a pause will prove the Fed is weak on inflation and that opens up the possibility of rampantly higher prices for goods and services.
In other words, it’s bearish either way.
So... who do you believe? How about both?
There’s an interesting trading pattern surrounding Fed announcements. Typically, whatever the stock market does on the day of the announcement is reversed on the following day.
For example, if the market rallies today after the release of the FOMC decision, then the odds favor a decline on Wednesday. Alternatively, if the market falls after today’s interest rate announcement, then Wednesday’s activity will likely be bullish.
And, just as a card counter won’t sit down at a Blackjack table until he’s certain the odds are in his favor, a stock trader should wait until after the market reacts to the FOMC announcement before placing his bet.
I still think there’s enough energy to rally the S&P 500 up to at least the 1,300 level. If we get close to that level right after the FOMC announcement today, then I’ll take profits on my long positions and establish a few short positions.
On the other hand, if the market falls immediately following the FOMC decision, then I’ll add to my long positions in expectation of a rally on Wednesday.
Trying to predict what the market will do immediately following the FOMC announcement is a gamble, and the odds are against anyone who tries to trade ahead of it.
But betting on a Wednesday reversal looks like a pretty good speculation...
Best Regards & Good Trading,
Jeff Clark

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