Stock market investors are ready for the first U.S. Federal Reserve interest rate hike in nearly a decade next week, but they may not be fully prepared for all of the nuanced remarks likely to accompany that announcement.
If the Fed lays out an aggressive schedule of future rate increases, stock markets could become very volatile and even plummet, say strategists who expect a market-calming central bank announcement detailing the patience of policymakers.
Activity in the options market suggests stock traders are being cautious ahead of the Fed policy meeting on Dec. 15-16, and options expiry at the end of next week could amplify volatility in either direction.
"If...(policymakers) came out saying that over the next two years they will raise by 'this' much, that would be very destabilizing," said Brian Battle, director of trading at Performance Trust Capital Partners in Chicago.
"The market will take great relief in the Fed communicating it will be very patient for the next increase."
Even so, traders hoping to profit on the Fed's expected statement lack a playbook. The markets haven't been through the current scenario of a rate lift-off after years in which the central bank's short-term interest rates have been locked near zero.
That could partly explain the jittery trading on Wall Street this week, during which volatility has risen and the benchmark S&P 500 dropped 3.5 percent.
A slew of economic data due to be released before the Fed meeting, including readings on growth in manufacturing, industrial production and consumer prices, could cause some choppiness if traders take any robust data as a sign that the Fed may be more aggressive with future rate increases.
Furthermore, markets could face an interruption next week if Congress and President Barack Obama trigger a government shutdown by failing to finish work on a $1.5 trillion government funding bill.
OPTIONS POSITIONING
That uncertainty has helped trigger bets in the options market by investors trying to cover themselves against a wide array of outcomes in stocks, and similar uncertainty has been apparent across other asset classes as well.
Crude oil futures fell to seven-year lows while the euro, expected to decline against the dollar as the Fed tightens, rallied after many covered those bets.
As expected, exchange-traded funds and individual stocks in rate-sensitive sectors such as financial firms and real estate investment trusts have attracted a lot of options trading activity betting on sharp moves - in both directions - in the wake of a Fed announcement.
"We are seeing a lot of heavy positioning" in front of the Fed, said Steven Sosnick, equity risk manager for Timber Hill, the market-making division of Interactive Brokers.
That positioning is leaning more heavily toward seeking protection against a broad stock market move lower, said traders who expect volatility to spike after the Fed meeting.
S&P 500 .SPX options expiring next Friday imply a 2.9 percent move in the index by the end of the week.
The CBOE Volatility Index .VIX, the market's favored barometer of trader angst, has crept over its long-term average of 20, after having stayed mostly below that level since early October. On Friday, it was up 28 percent at 24.72.
That level is higher than futures show the VIX going forward, signifying that traders are more worried about near-term volatility than they are about a long-term breakdown.
But a sharp move to the downside could be amplified since the Fed decision comes just two days ahead of "quadruple-witching," when options on stocks and indexes and futures on indexes and single-stocks all expire, making the index particularly prone to a jump in volatility.
JPMorgan derivatives analysts estimate that nearly $1.1 trillion of S&P 500 options are set to expire on Friday morning, about 60 percent in put options, typically used as portfolio hedges.
In case of an adverse reaction in stocks, the accumulation of large blocks of open SPX put contracts at the 2,000, 1,950, and 1,900 levels, could force more selling. Market makers who have sold those contracts would be forced to sell equities to reduce their risk.
This kind of activity was one of the key reasons for the market selloff in late August, when the S&P entered its first correction in more than four years.
