Trader Talk

Gaming the Fed rate hike decision

Consumer discretionary stocks lead open: Pisani

Trying to reduce the September Federal Open Market Committee meeting to game theory, the question becomes, "How do you win?"

Let's get one thing clear. A lot of traders have already won, and so the question becomes how to avoid losing. In the last five days, the is up 2.2 percent. A lot of traders have adopted a "sell the news" position. In other words, they either sold at the close Wednesday or will lighten up on the announcement, regardless of what the decision is.

Read More When the Fed raises rates, here's what happens

I'm in the minority on this, but I believe the most likely scenario for the markets to rise still rests on the "one and done" scenario.

  1. The Fed hikes interest rates by 25 basis points.
  2. Yellen gives a commanding press conference that paints a reasonably optimistic economic forecast.
  3. She states—over and over again—that the Fed is planning for a very long glide path to higher rates.

There's a lot of "ifs" here. If Yellen stumbles, if she fails to convince that the economy is strong enough, or implies another rate hike is imminent, the whole thing could fall apart. A muddled message would be a disaster.

How to mitigate the chance of a disaster? Two more things are necessary:

  1. Lowering the "dots" or the expectations of the FOMC members, about the path of the rate hike. That immediately implies a second hike is a bit farther off.
  2. Use an implementation note to explain yourself.

Buried in the June FOMC minutes was this statement:

"Participants also discussed plans for publishing operational details regarding the implementation of monetary policy around the time of the first increase in the target range. All participants supported a staff proposal for the Federal Reserve to issue an implementation note that would communicate separately from the Committee's postmeeting policy statement the specific measures to be employed to implement the FOMC's decision about the stance of policy."

Read More Rubenstein: Why the Fed won't raise rates now

So if they do hike, the Fed is likely to issue a note that would explain the expected path of rate hikes. The hope, obviously, is that this might dampen market volatility

I know, it's all very risky. But it may be less risky than simply re-iterating the data is getting better and implying the Fed will raise rates sometime in the near future. Hanging the Sword of Damocles over the markets month after month creates endless uncertainty, particularly when the outcome seems inevitable.

What is the market saying? It is sending mixed messages, implying there is no unified opinion. I noted yesterday what happens when the market looks like this:

  • Stocks: up
  • Gold and commodities: up
  • Dollar: down
  • Banks: mixed
  • Volatility (VIX): downtrend

That type of market would seem to imply a rate hike is unlikely. However, bond traders have been screaming that two-year Treasury yields have been moving up aggressively recently, to the highest levels since 2011. Since the short end of the curve is particularly sensitive to Fed moves, that, the hawks assert, implies bond traders think something is going to happen.

Read More Unconventional ways to play the Fed decision

There's one other modest wrinkle. Tomorrow is a quadruple expiration tomorrow, the quarterly expiration of stock index futures and options, as well as individual stock futures and options.

While this is not the big event it used to be (thanks to the growth of weekly and month options), will likely create much higher volume than usual since it occurs on the day after a Fed meeting.