Buckle Your Seatbelt for a Market Correction

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CME: E-Mini S&P 500 Options ( ES1!)
Last week, investors cheered as the Fed Chair reinforced that interest rate cuts are coming despite hot inflation readings in the last two months. For the full week, the Dow was up by nearly 2% in its best week since December 2023. The S&P was higher by 2.3% and the Nasdaq jumped 2.9%. The three major US stock indexes are on track to positive gains five months in a row.

Bull Market Carries on Despite Fed Hold
This is the fifth time that the Federal Reserve kept the Fed Funds rate unchanged at the 5.25%-5.50% range. The last of 11 consecutive rate hikes occurred in July 2023.

There are only eight FOMC meetings left in 2024. However, investors are pricing in at least three rate cuts by the end of the year.

According to CME Group’s FedWatch Tool, the probability of a 25-bp cut in June is 75.5%. There is a 77% chance that Fed Funds move to 4.50%-4.75%, indicating three rate cuts. Four rate cuts, which will be a full percentage point lower, is priced at 43% probability.
(Link: cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html)

Bullish investors pushed major assets up in the first three months of 2024:
• Bitcoin is up 48% year-to-date, while Ethereum is up 44%;
• S&P 500 gained 10.5% YTD, while Nasdaq 100 advanced 11.1%;
• Gold broke new record and was up 4.7% YTD;
• Dollar Index is up 2.2% YTD.



In my opinion, rate cut assumptions are too aggressive. This Fed is known to be highly data dependent. The Fed Chair had said that upticks of CPI data two months in a row did not change his assessment of inflation trending lower. However, if CPI continues to beat expectations, the Fed Chair may very likely correct his assumptions.

The timing of the first rate-cut is highly uncertain. CPI data in March could be a breaking point, setting the direction for interest rates for the rest of the year. Even if rate cut occurs as expected, the Fed would likely take it slowly, pausing to evaluate the lagging impact.
Therefore, the number of rate cuts could also be significantly fewer than market expectations. Recall that a few months ago, investors were pricing in six to eight rate cuts in 2024. Even though their expectations have been halved, I think they are still too aggressive. In my opinion, we could see one or two rate cuts this year. Any upticks in inflation could push rate cut into 2025.

Trading with E-Mini S&P Options
The Bureau of Labor Statistics (BLS) is scheduled to release March CPI data on April 10th. We could build an event-driven strategy focusing on this data release. If CPI data comes in strong, US stocks could face a major correction as investors lower their expectations for Fed cuts.
CME Group E-Mini S&P 500 Options provide leverage and capital efficiency. Options are based on futures contracts. Contract notional is $50 x S&P 500 Index.

On March 22nd, the June futures contract (ESM4) is quoted 5,289.75. The out-of-the-money (OTM) call strike 5,100 represents a 3.6% discount on the current market price. It is quoted at 63. To purchase put options, a trader would need to pay a premium upfront for $3,150 (= 63 x 50). Hypothetically, if the index moves down to 5,000, the put strike would be 100 points in-the-money (= 5100 – 5000). The trade will gain $5,000 (= 100 x 50). Considering the upfront premium, the theoretical return on our put strategy will be 58.7% (= 5000/3150 – 1).

If the market moves against the trade, with the index value staying above the strike, the trade will lose money, limited to the upfront premium.

Options traders could find CME’s Options Calculator a valuable tool in structuring their options strategies. The best part, it is free.
cmegroup.com/tools-information/quikstrike/options-calculator.html

Happy Trading.

Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.
CME Real-time Market Data help identify trading set-ups and express my market views. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs tradingview.com/cme/