How To Trade The Fed Rate Hike Using Options

June 19, 2017

Last week was a busy news week, but the most important story for investors was the Fed rate hike. While it was no surprise the FOMC decided to raise rates, it’s noteworthy for the key Fed Fund interest rate to finally climb above 1%. We’re almost to a point – not quite – where interest rates may matter again.

Perhaps more importantly, the Fed outlined its plan to start reducing its $4.5 trillion balance sheet accrued during and after the financial crisis.

While we don’t know for sure how this is going to play out, the markets did show some concern with a moderate selloff after the news came out.

Let’s leave the discussion of the Fed balance sheet for another time.

For now, we’re going to focus on how to trade the Fed rate hike; it could be the start of a sustained rise in interest rates over the next several years.

In case you don’t remember your Economics 101, the Fed will raise rates for essentially two reasons – to keep inflation in check or if unemployment gets too low.

The inflation reasoning is obvious, as we all know high levels of inflation are bad. So what about that second point? Does it surprise you? It’s true, there can be a level of unemployment which is too low.

You see, there’s this thing called full employment, where everyone who wants to be employed is basically employed. That number is around 4.5% in the US, and it’s where we are at right now. As you drop below the full employment level, it can really start to distort the dynamics of the labor market. Companies will have to start paying more to retain or attract employees, which can erode profits and – you guessed it – lead to inflation.

The Fed is engaged in a tricky balancing act – trying to keep inflation low and the country at full employment. Right now, inflation isn’t a concern. In fact, judging by the latest CPI numbers, it’s even a little too low. On the other hand, companies show no sign of slowing the current hiring trend. Of course, that’s a good thing overall for those who want a job. Nevertheless, the Fed still has to keep the economy in balance, and that also means making sure a brisk pace of hiring doesn’t turn into a problem down the road.

Okay, so the Fed just raised its key rate by a quarter point due mostly to labor market conditions. What’s more, tight labor conditions don’t appear to be going away anytime soon. That means we can probably expect the Fed to continue raising rates, albeit slowly. (The current forecast is for three rate increases per year, which means one more in 2017.)

With that in mind, what trades can we make to take advantage of this scenario? What’s the best way to trade higher expected rates?

One sector which is highly sensitive to rate changes is the commodities sector. Outside of a crazy fundamental situation (like a massive supply shortage or something similar), commodities almost always trade predictably when interest rates change. Without getting into details, you can safely assume higher rates mean lower commodities prices.

Precious metals are one reasonable way to trade interest rates, but I happen to like oil this time around. With crude oil only being in the mid $40 per barrel range, it can be traded with options quite cheaply.

Take a look at the chart of the United States Oil Fund (NYSE: USO), the most heavily traded oil ETF.

As you can see, oil has been trending lower, in part due to the expectation of higher rates. Of course supply/demand dynamics are also involved, but it’s no surprise oil is moving lower as rate expectation rise.

Here’s the thing…

Oil is already at the lows of the year. Yet, interest rates going up suggest it will go even lower. On the other hand, technically speaking the price of oil is likely to go back up a bit before it goes down. So what do you do in that situation?

Once again, this is where options are a great, well, option. Because USO is so cheap, the at-the-money straddle is also super cheap. Keep in mind, the straddle is when you buy the at-the-money (closest to the current stock/ETF price) call and put at the same time in the same expiration period. You make money if the underlying asset moves a reasonable amount in either direction.

For example, the August 18th USO 9 straddle (with the ETF at $9.18) only costs about $0.90. That means you make money if USO goes to $8.10 or below or $9.90 or above by August expiration (about two months of control). That’s a super cheap way to trade oil and interest rate expectations. We have both the technical and fundamental case covered, and all for just $90 per straddle!

– Jay Soloff

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Source: Investors Alley