How to Trade Market Whipsaws Right After Fed Meetings

By TradeSmith Research Team

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Editor’s Note: Today we feature a guest essay from John Jagerson. John is a CFA and CMT charter holder and the co-editor of Predictive Alpha. He is an expert technical analyst who creates technology, education, and market analysis that drives investor success.

The Federal Reserve meets approximately eight times yearly to make an interest rate decision, and its latest meeting has been happening this week. As you know, these meetings usually trigger frustrating whipsaws and volatility.

Market whipsaws are fast market moves that happen in volatile market conditions. Investors can often end up stuck in losing positions if they do not play the whipsaw correctly.

After each Federal Reserve meeting, a decision announcement follows and approximately every other meeting includes a lengthy press conference and detailed economic projections from the Fed members.

I have been following Fed meetings as an investor since the Asian financial crisis in 2001, and over that time, an interesting intra-day pattern has emerged on Fed days, which has only become more pronounced over time.

It goes like this: the Fed issues its announcement with or without the projections, and the market reacts by rising or falling. If the initial reaction is +/- .5% or larger, the market reverses that gain/loss by the end of the day 74% of the time.

For example, the last time the Fed made an interest rate decision on July 26, the S&P 500 rallied .59% within the first 40 minutes following the release and then completely retraced those gains before the close of the market. You can see that whipsaw in the following chart.

This reversal works both ways. If the initial reaction is negative, the market retraces that movement before the close more than 70% of the time.

Why Does This Happen?

My hypothesis for why this happens is related to the issues that cause flash crashes.

Automated trading software creates most of the volume in the market on a given day. When significant new information hits the market, these algorithms overreact and normalize within an hour or two.

Unfortunately, I can’t test my hypothesis without getting access to the programs that funds, banks, and major traders use, but I think it’s a reasonable guess.

More importantly, I believe this is why the pattern will persist in the future.

Can an Investor Profit from the Pattern?

This is one of the few times I would ever suggest that it makes sense to take a trade that will likely be measured in minutes or hours.

Investors could trade against the initial reaction to the Fed by shorting the market or stocks sensitive to interest rate fluctuations if the response is initially positive.

Or an even better idea would be to time a new long entry in rate-sensitive stocks when the reaction is overdone to the downside.

Anyone with long-term experience in the market can tell you that finding a tradeable intraday pattern will be extremely difficult without the advantages of institutional backing.

So, when one emerges that has been as reliable as anything can get, it deserves a little attention.