The Fed, Earnings, Volatility and Profiting

The Fed is committed to reigning in inflation at all costs and each interest rate hike takes us one step closer to Powell’s pivot on interest rates.

With the next rate hike less than two weeks away, there’s a 92% probability we’ll see a quarter-point rate hike. Since the expectation already baked into the stock market, I wouldn’t expect much of a reaction from the stock market on this news alone.

And yet, I expect market volatility to rachet up a bit regardless.

So, if fully anticipated interest rate changes don’t upset the market, let’s look at some other things to consider.

Until we hear Chairman Powell’s tone change from offense-driven rate hikes to a more dovish tone, the biggest surprise we may see in the near-term will be in individual corporate earnings.

And, over the next few weeks we’re going to see some heavy hitters, like Apple, Inc. (AAPL), Microsoft, Inc. (MSFT) and Amazon, Inc. (AMZN) report their earnings, which can shake things up.

These three stocks are important because they make up over 15% of the S&P 500 holdings. Crushing earnings reports on any of these stocks can easily cause a ripple in the entire index.

Volatility doesn’t always heat up from news-worthy items that have already been released, but instead fear builds up around the unknown – such as the financial health of companies.

You know I love trading volatility, so with earnings season in full bloom, you’ll be able to cash in on the volatility through opportunities identified by my Brutus software.

Let’s talk about the Fed’s commitment is impacting volatility, and the volatility strategy that allows you to profit from it.

The Feds Commitment

Federal Reserve Chair Jerome Powell said: “While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses,” Additionally, “these are the unfortunate costs of reducing inflation.”

Chairman Powell’s commitment is strong and we’re already seeing the effects in the overall CPI reading, which was lower again this month. Also, in the attempt to curb inflation, wage growth needs to be suppressed, and there are signs of potential success from the Fed here, too.

At 3.5%, the unemployment rate has fallen to 2022 lows. Wage increases are part of Powell’s plan to curb inflation, and, although wages rose in January by 0.3%, it was the smallest increase since August 2021, so this is additional good news for the Fed.

And so the battle continues for Powell who hopes to reign in inflation while orchestrating an economic soft landing at the same time, and although labor and wages are starting to see positive moves, corporations have been coping with interest rate hikes throughout 2022, and now again in 2023.

The repercussions of rate hikes on company financials are just beginning to be unveiled, which will be a key reason for market volatility in the coming weeks and months of this year.

How to Profit from Uncertainty and Implied Volatility

We’re in the thick of earnings season and the volatility in the general market is near a 13-month low which means option prices are not as inflated as we’ve they were for most of last year.

However, when volatility gets low, we’d expect to see at least a slight bounce in, and, due to the inverse relationship the volatility index has with the S&P 500 index, a bullish bounce in the CBOE Volatility Index (VIX) would mean a decline S&P 500.

We started to see the volatility bounce on Wednesday and Thursday of this week.

In the VIX chart above, the red markings represent low and high points for volatility over the past year. On the far right you can see the index very near the 13-month bottom.

A rise in volatility would indicate that option premiums will become more inflated, but the rollercoaster ride you can see in the volatility chart above occurs in individual stocks as well – especially around events such as earnings.

Although there are plenty of ways my subscribers can profit from swings in market volatility, let me show you how to profit from the swings of implied volatility during earnings season.

The graph above illustrates swings in Implied Volatility (IV) on AAPL. The red line represents implied volatility. Notice how IV swings from low to high levels similarly to the VIX chart we looked at above.

There’s a difference in the IV on this individual stock chart vs the VIX, however. Notice the extreme levels of IV periodically. These mega swings occur around earnings time.

I highlighted the first three mega IV swings with red ovals. Each of these surges in IV occurred just prior to an earnings report. The last oval on the far right represents Apple’s upcoming earnings report.

The question mark indicates the surge is unknown, but as you can tell from the prior earnings… it will happen.

Not many option traders understand the power of volatility in options, but my Vega Burst subscribers are keenly aware of the implications and opportunities.

You see, rising IV in options means the market value of options becomes inflated. Imagine an option worth $100 under ordinary circumstances. Now, imagine the same option worth $150 simply because implied volatility rose higher. This illustrates the power of rising IV – it simply means option market values become inflated.

There are a lot of other factors involved with option pricing of course, but now you have a much better sense of how we’re profiting with volatility swings during corporate earnings reporting.

I may have several strategies involving trends, contrarian trading and seasonality’s, but when it comes to earnings season four times per year, I like to hit it hard with our volatility trading strategy.

Be sure to join in the discussions each Monday through Wednesday at noon.

Until next time,

Tom Gentile
America’s #1 Pattern Trader

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