Short-Term Volatility Increases
The slight bounce in European markets means very little as we are all waiting for the Federal Reserve’s decision later today. This holding pattern ahead of a major announcement is pushing up short-term volatility. For derivative traders, this means the price of options, especially those expiring this week, is becoming expensive.
The Fed’s commentary on inflation is the main event, especially after the latest CPI print held stubbornly at 3.1%. With the August jobs report also coming in hotter than expected at 210,000, there’s a real fear the Fed will signal that rates need to stay higher for longer. This uncertainty is why the VIX, the market’s fear gauge, has crept above 18 this week from a low of 14 last month.
Given the risk of a sharp downward move, this is a critical time to check portfolio hedges. Buying put options on major indices like the S&P 500 or the Eurostoxx 50 offers a straightforward way to protect against a hawkish surprise from the Fed. It’s a classic defensive play when the market is on a knife’s edge like this.
Expected Volatility Crush
We expect to see a significant “volatility crush” immediately following the announcement, regardless of the market’s direction. This means implied volatility will drop sharply, making any options bought today instantly cheaper. Traders considering selling premium through strategies like iron condors are betting the market’s actual move will be less dramatic than the high volatility currently implies.
We only need to look back to the cycle of 2022-2023 to see how markets reacted to the Fed’s inflation fight. A surprisingly hawkish tone can trigger multi-week sell-offs, and traders are positioned for that possibility. The memory of sharp drops following similar meetings is keeping this morning’s buying muted.
