Lower Inflation Data Can’t Sustain Market Rally

“Lower than expected” inflation numbers invigorated traders and sent the stock market rallying higher Tuesday morning.

The euphoria – that at one point boosted the Dow by more than 150 points – faded into the afternoon and the three major indexes closed the session with modest gains.

Will this spike in traders’ euphoria mixed with slightly lower inflation numbers be enough to alter Federal Reserve (Fed) plans to raise benchmark interest rates tomorrow?

Market surge falters after lower inflation data

How much has inflation moderated the past few months?

The stock market surge today was spurred by a U.S. Consumer Price Index (CPI) report showing inflation jumping by 7.1% in November compared to last year. Econonimists anticipated a 7.3% annual uptick. The “cooler” tally excited the market rally during the cash session.

Inflation numbers are still holding near 40-year highs experienced in the early 1980s. November inflation rose 0.1%, a slight increase over the October level and below an anticipated .3% rise.

CPI, which measures inflation on a variety of consumer goods and services, appears to show inflation peaking at 9.1% annually in June.

But the measure of core inflation, which excludes the less stable indicators of food and energy, creates an uncertain scenario leading into the Fed meeting tomorrow.

The November CPI numbers show annual core inflation rising 0.2% higher in November (less than the 0.3% in October) and at 6% annually. Both were lower than levels in the previous two months. The 6% annual core inflation rate remains three times the acceptable level for the Fed.

Core inflation is the data point the Fed looks at when considering raising benchmark interest rates. The Fed has staunchly touted for months its aggressive resolve to lower annual core inflation down to 2%.

For retail traders, trying to anticipate market reaction to inflation data and unknown Fed decisions can make navigating the stock market difficult.

Stock options trading strategy targets volatility

There is a stock options trading strategy that allows traders to target price movement up or down as the market moves in volatility.

Allison Ostrander, Director of Risk Tolerance at Simpler Trading, has used this strategy to trade previous Fed-induced market moves on the S&P 500 (SPX). The strategy allows her to target trades without stressing over having to pick the “correct” direction after an economic news event.

Allison builds trade setups in volatile conditions using the compound butterfly spread strategy, particularly call and put broken wing butterfly setups. This is a way to combine different butterfly strategies with a higher potential for a win.

“This follows the idea that I’m uncertain about which way price action will move, but I know that there is a good chance the move will be volatile,” Allison said. “By setting up the trade this way, I can have the market go higher off the economic and Fed news events, and I can have the market go lower off the same.

“It doesn’t really matter which way the market goes as long as there is a good chance there is a high probability of volatility and if the underlying price can get into my strike price.”

To understand this further, note that a butterfly spread is generally a neutral strategy that involves buying and selling options with different strike prices and the same expiration date. There are multiple variations of a butterfly.

A compound butterfly is a more advanced version of this strategy that involves combining different types of butterfly spreads in order to create a more complex and potentially more profitable position. A compound butterfly is a complex options trading strategy that involves combining multiple options positions in order to profit from a specific price movement in the underlying stock.

Allison is using this strategy as a balance against volatile market moves up or down. This strategy can be considered as a low-risk, high-reward approach. Allison, who has traded for years, has developed a thorough understanding of options trading and the risks involved before using this strategy.

When building a broken wing butterfly setup, Allison looks on both the call and put side of strike prices for a “broken debit wing butterfly.” The idea is that the debit spread is wider than the credit spread.

“The thought process is that if we get a strong bounce there is a good chance that we could go at or in the money on these trades,” Allison said.

Why care what Fed says, does?

The Federal Reserve, also known as the “Fed,” is the central banking system of the United States. 

This year the Fed has played an influential role in how the stock market moves. The central bank has been actively working to curb inflation.

Fed actions have come in the form of raising benchmark interest rates – which affects everything from home mortages to car loans – and various other financial policies.

The central bank is responsible for implementing monetary policy, regulating banks and other financial institutions, and providing financial services to the government and other organizations. The Fed was established by Congress in 1913 to provide stability and economic growth, and it is considered an independent agency that is not subject to political interference. The Fed is governed by a board of governors, which is appointed by the U.S. president and confirmed by the Senate. The chair of the Fed is currently Jerome Powell.

The Federal Open Market Committee (FOMC) is the main policy-making body of the Federal Reserve. It is responsible for setting monetary policy, including the target range for the federal funds rate, which is the interest rate at which banks lend money to each other overnight.

The FOMC meets regularly, typically eight times per year, to review economic and financial conditions and to decide on appropriate monetary policy actions. The committee is composed of the seven members of the board of governors of the Federal Reserve, as well as five of the 12 presidents of the Federal Reserve Banks. The chair of the FOMC is the chair of the Federal Reserve – Powell.

FOMC decisions can have a significant impact on the economy, and its meetings are closely watched by market participants.

Follow steps for compound butterfly spread strategy

Nothing is certain after highly-anticipated economic news events. So if the market gaps higher or lower beyond the compound butterfly setup, the trade can cash settle for one or the other butterfly for a win. On occasion, Allison said, this can provide a gain on both sides of the butterfly setup.

Following are some steps to consider when using a compound butterfly spread strategy:

• Identify – Target a stock that may experience a significant but limited price movement ahead.
• Choose – Select strike prices and expiration dates for the options that are part of the compound butterfly spread.
• Create – Set up the compound butterfly spread by buying and selling the necessary combination of call and put options with the chosen strike prices and expiration dates.
• Monitor – Price movement is expected to move fast, so adjust the position if necessary to maximize potential profit and protect against risk.
• Close – Traders must close the position before expiration by buying back or selling the options initially purchased or sold. If the trade is on the S&P 500 (SPX) traders can technically let it cash settle at expiration without risk of assignment.

At all stages of her trading Allison manages risk vs. reward potential based on her pre-established risk management plan. She has a pre-determined amount of capital she will risk with any options trade setup.

“Sometimes these volatile moves, especially when they are back-to-back like with the CPI and Fed data, can actually benefit in taking profits on both sides of this strategy,” Allison said. “Even if it moves in one direction and keeps going I still know I have that potential of profit on the call side or the put side.”

Every trading strategy involves a level of complexity and risk. Traders need to develop experience with options trading and understand the risks involved. Traders can work with Allison as she navigates this volatile market. Access her training today.