As the worst inflation in four decades was picking up steam, the Federal Reserve dragged their feet but finally started to cut back on their balance sheet and raise interest rates. Successive interest rate hikes by the Fed have resulted in a miserable stock market in 2022 (but not for Top Gun Options members). 2022 was the year when Amazon.com made history for being the first company ever to lose $1 trillion in market capitalization. Investors far and wide lost their shirts while we routinely were able to turn on a dime and potentially print money with every market downturn as well as every bear market rally. Now, as Fed interest rate increases are starting to slow inflation, they are doing so by slowing the economy. The question is if the Fed will succeed in fixing inflation without driving the economy into a deep and prolonged recession, the much-feared “hard landing.” Options trading for a hard landing is a different matter than how investors deal with this likelihood.
What Is a Hard Landing
The name hard landing comes from aviation when a plane lands at high speed and does not crash but may still cause damage to the aircraft and result in injuries. When the Fed raises interest rates excessively in order to control rampant inflation the economy may not crash but may experience economic damage and injuries (business failures and unemployment). When this occurs, it drives stock prices down, turning 401k’s into 301, 201, or 101k’s. Meanwhile, options traders simply pivot and keep making profits.
Fed Walks a Tightrope When Raising Rates
The problem for the Fed is that if they do not hit the brakes on the economy by raising rates sufficiently and frequently enough, inflation continues and becomes harder and harder to turn around. And if they hit the brakes too hard with excessively high rates hikes too frequently, they create business and employment conditions that exceed their goals for causing slowing but not collapse. There is always a lag between Fed actions in raising or lowering rates and when maximum effect hits the economy. The stock market typically reacts to rate increases with the expectation of those later economic effects.
Buying the Rumor and Selling the News for Fed Rate Changes
Because the market is afraid of excessive rate increases and pleased by the opposite, traders parse every word of every head of every branch of the Federal Reserve and especially of those members of the Fed who are voting members of the Open Market Committee which is who actually sets the rates. Depending on market sentiment regarding these pronouncements the market may rise or fall. The Fed bases its rate decisions on the consumer price index, other measures of inflation, and the non-farm payroll numbers. As each of these report dates approach the market speculates on the likely numbers and either drives prices up or down. Then, in succession, these reports are published and the market adjusts prices accordingly. More often than not anticipation drives prices past when the results will support. As such options traders commonly profit by assuming that prices will go too high (or too low) just prior to an economic report and then lower (or higher) immediately afterward. When the Fed actually sets rates after an Open Market Committee meeting the same back and forth market reaction is common.
Longer Term Expectations of a Hard Landing and Options Trading
We have written about the risk of wishful thinking when trading options. When the economy is heading for a hard landing, some may wish otherwise but need to avoid trying to trade the market they would like to have rather than the market as it is playing out right in front of their eyes. We see this again and again like during the Covid crash where naïve traders and investors repeatedly jumped into a brief bear market rally and got burned. Although we routinely profit from short term market movements when trading options, we remain fully aware of where fundamentals are taking prices and routinely profit as wishful thinking of too many traders creates situations that are profitable for us and devastating for those who are not hedging risk or reading the market accurately.