Most traders, when hearing the combination of trading and rate decision, have an immediate reaction. That is to avoid, avoid and one more time, avoid the situation.
If you are used to trading on technical indicators, then like most traders, a rate decision becomes your worst enemy. It’s a macro event that has deep fundamental connotations.
It can hit you like a black swan, and there is no technical indicator that can help you with that. So, the best idea would be to disengage, right? Well, not exactly. Here are a few tricks that I use that can step up your game on trading interest rates.
A Rate Decision is a Game of Chance
The first thing you have to realize with rate decisions (and, of course, I mean a Fed rate decision) is that it’s completely a game of chance.
No one really knows what will happen. And no indicator in the world can tell you with complete certainty what will happen. But you can have a good indication of what is expected and the market’s possible reaction. And that, really, is just enough. But unlike the conventional wisdom, the trick to playing this information is to go against the mainstream.
If a market is certain something is going to happen, in this case a rate hike, then it’s already positioned for it. That means your upside is high.
What if the market is caught off guard and gets a decision it didn’t expect? You could be drowned by a tsunami of traders is deep fear, eager to get out of their position.
So, if you went against the market consensus and bet on a rate hike it would have played out in one of two ways. If you were wrong, you’d think, oh well, it was already priced in. It was expected and your loss is minimal because the market was prepared for that decision.
Essentially, the move already took place, before you opened your trade. But if you were right and the consensus was wrong? There would be a tsunami, of course, but you would have been on top of it, potentially gaining big. In other words, you risked little for a potential big gain, a classic risk reward trading bet.
Your Tool Box
When it comes to rate decisions by the Fed, CME has the ultimate tool called FedWatch. The FedWatch essentially created a probability gauge for a Fed rate hike within a specific month. Let’s look at the probability level for a rate hike for September.
Yes, that’s the one where the Fed did not make a move. As you can see, the FedWatch tool indicated a 25% chance for a rate hike. That also means a 75% probability of no change. Now, as you can see in the chart below, as soon as the Fed announced its decision the Dollar index fell. But it fell by roughly 100 pips, hardly a hefty sell off.
In fact, support levels weren’t even broken at the time this article was written. Meaning? If you had taken the other side of the market consensus (with the 25% chance), you got it wrong. In the end, you got hit by 100 pips–ultimately, no big deal.
But what if the Fed had made a move? As you can see, the Dollar index was already close to its support levels. That means that traders were skeptical.
A fulfillment of the 25% chance would have caught the market off guard and would have resulted in a panic rally of the Dollar index. Get the idea? Of course this is relevant for all FX pairs related to the dollar such as the EUR\USD or the USD\JPY.
When It’s Not Worth It?
Of course, there are situations where it’s not worth it to engage. For example, if we move forward to January 16, you can see the market is pricing in a near 50/50 chance that the Fed will make a move. That means the market is not sure.
That means that Dollar index, or even any other Dollar pair, might swing either way. And that means it’s impossible to make an educated guess.
But what if the chances of a rate hike were higher than 60% and the Dollar was closer to its highs? A decision not to raise rates would have caught the market off guard. For a trader, it might have been wise to take a short position before the decision. Of course, there are many more layers and nuances that can be added which I will cover at another time.
In conclusion, there are no guarantees in life. But if you’ve ever wondered if you can step up your game on trading a rate decision, now you’ve got my two cents.