Selling ETF Invesco QQQ Trust to hedge after the rate increase

Exchange: NASDAQ

Sector: Financial

Industry: Exchange Traded Fund

Entry strategy

Price: $184,5–186,0

Stop-loss: over $191,56

Take profit: minimal aim — $178, then $170.

Investment horizon: up to 2 months

Fundamental analysis

Since December 2015, the US Federal Reserve has been consistently tightening its monetary policy. The regulator raises the rate and reduces the assets on the balance sheet (see Graph 1).

Graph 1. Interest rates change in the US in the period from 2014 Source: Investing.com — Open original image

The contractionary monetarypolicy affects markets in the short and long term. The long-term impact is well described in the economic literature and scientific papers. In this recommendation we will describe the short-term.

Details of the long-term impact of the Fed rate on video:

Dynamics of the S&P 500 index ($SPX) after the Fed rate increase. Statistical analysis

Since the US Federal Reserve decided to change monetary policy it has raised the interest rate seven times.

    We analyzed how the $SPX has been changing in the next six weeks from the decision announcement. Graphs 2–8 show the dynamics of the S&P 500 index changes during the first two and a half weeks after the regulator’s decision.

  • For the analysis, we used hour intervals, closing prices.
  • The graphs reflect the cumulative change in the index to a specific hour compared to the level at the time of the Fed announcement.
Graph 2. The change in the S&P 500 index after the US Federal Reserve rate increase from 0.25% to 0.5% at the meeting on the December 16th, 2015 — Open original image
Graph 3. The change in the S&P 500 index after the US Federal Reserve rate increase from 0.5% to 0.75% at the meeting on the December 14th, 2016 — Open original image
Graph 4. The change in the S&P 500 index after the US Federal Reserve rate increase from 0.75% to 1% at the meeting on the March 15th, 2016 — Open original image
Graph 5. The change in the S&P 500 index after the US Federal Reserve rate increase from 1% to 1.25% at the meeting on the June 14th, 2017 — Open original image
Graph 6. The change in the S&P 500 index after the US Federal Reserve rate increase from 1.25% to 1.5% at the meeting on the December 13th, 2017 — Open original image
Graph 7. The change in the S&P 500 index after the US Federal Reserve rate increase from 1.5% to 1.75% at the meeting on the March 21th, 2017 — Open original image
Graph 8. The change in the S&P 500 index after the US Federal Reserve rate increase from 1.75% to 2% at the meeting on the June 13th, 2017 — Open original image

    Graph 9 shows information about the dynamics of the S&P 500 index after all seven rate increases.

  • T0 — the moment of the decision to raise the rate announcement,
  • Т+1 — next trading hour and so on.
Graph 9. The change in the S&P 500 index after the US Federal Reserve rate increases — Open original image

The main conclusions from the study

  1. In most cases, after the rate increase by the US Federal Reserve, the value of $SPX tends to decline in the short term.
  2. The average duration of a steady decline in the index is about 2.5 calendar weeks.
  3. The minimum value of $SPX is reached between the second and third trading weeks after the rate increase.
  4. After the second and fifth increases (on December 14th, 2016 and December 13th, 2017), the value of $ SPX did not decrease. The stock markets in these periods were influenced by rising trends (New Year rally). At the same time, the index remained within the short-term lateral trend forabout the same 2.5 calendar weeks.
  5. The most significant drawdown of $SPX after the Fed rate increase for the study period is 10.85%. It was achieved in December 2015, after the first increase. The average drawdown is about 1.5%.

Using the statistical advantage to hedge portfolios (trading plan)

    Each investor decides on how to manage risks of the investment portfolio in his own way. We expect some correction of the indices after the interest rates increase. In this situation, there are several options:

  • to buy shares cheaper than they are traded on the market at the moment,
  • to decrease leverage,
  • to hedge using derivative financial instruments,
  • to close all positions and wait for market reaction.

Any solution has advantages and disadvantages, risks of receiving losses and shortfall in profits.

We offer a tool with an average beta of 1 or more to hedge the portfolio from a possible decrease in risk appetite in the next 2–4 weeks. This is selling of ETF on the index of the technology sector NASDAQ 100 ($ QQQ).

Graph 10. Technical analysis of ETF Invesco QQQ Trust ($QQQ). Source: TradingView — Open original image

Published on the 26th of September, 2018