Inflation Is Coming
The Federal Reserve boosted short term interest rates. The policy setting Federal Open Market Committee voted unanimously to increase the federal funds rate target range to 1.5% to 1.75%, up 0.25% from the previous level.
The official announcement noted, “The economic outlook has strengthened in recent months. Officials also updated their quarterly forecasts which indicated members were divided on the outlook for the benchmark interest rate in 2018.
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Seven officials projected at least four quarter-point hikes would be appropriate this year, while eight expected three or fewer increases to be warranted.
Overall, U.S. central bankers projected a median federal funds rate of 2.9% by the end of 2019, implying three rate increases next year, compared with two 2019 moves seen in the last round of forecasts in December.
Rates are expected to reach 3.4% percent in 2020, up from a forecast of 3.1% in December, according to the median estimate.
The Fed also noted that inflation on an annual basis is “expected to move up in coming months,” a change from the most recent statement which said inflation would “move up this year.” Inflation is still expected to stabilize near the Fed’s target of 2%.
Other Signs of Inflation Also Moved Markets
Earlier in the day, General Mills (NYSE: GIS) fell after the company lowered operating-profit guidance for its full fiscal year ending in May. The maker of Cheerios cereal, Yoplait yogurt and Progresso soups now forecasts adjusted earnings-per-share growth of zero to 1% for the period, down from its earlier guidance of 3% to 4% growth.
The company cited higher commodity prices—including grains, nuts and dairy—as well as rising logistics and freight costs.
On a conference call, management was contrite for not catching the trend of accelerating inflation earlier, and it outlined plans to respond by cutting costs, reconfiguring logistics networks and raising some prices.
But, The Wall Street Journal reported, “analysts on the call voiced skepticism that General Mills has room to pass higher costs on to consumers in the current tough environment. Among other factors, discount grocery chains are taking market share and pressuring suppliers to keep prices low.
Shoppers also are increasingly willing and able to compare prices online. During a previous bout of commodity price inflation a decade ago, companies like General Mills raised prices stealthily by shrinking package sizes, but this approach has inherent limits.”
The stock’s selloff was rapid on the announcement.
This continues a long term down trend in the stock.
Price pressures seem unlikely to abate anytime soon. The company said freight costs in North America were near 20-year highs in February while food prices were also higher than expected.
“We are seeing an unprecedented rise in logistics costs,” Chief Executive Jeff Harmening said in an interview. For food costs, he said, “the inflation is not unprecedented, but we are a quarter late in reacting.”
The stock is unlikely to rebound until its operating performance improves.
A Trading Strategy While Awaiting Better News
To benefit from the expected weakness in the stock, an investor could buy put options. But, high prices on put options suggests an alternative trading strategy. The option premium is high because the expected volatility of the stock is high. Options that are based on selling an option can benefit from high volatility.
In this case, with a bearish outlook, a call option should be sold.
Selling options can involve a great deal of risk. credit spread option strategy can be used to limit the potential risk of the trade.
One strategy that is important to consider is the bear call spread. This trade uses two calls with the same expiration date but different exercise prices. Traders buy one call and sell another call. The exercise price of the call you sell will be below the exercise price of the long call, so this strategy will always generate a credit when it is opened.
The risk profile of this trading strategy is summarized in the diagram below.
Source: The Options Industry Council
The trade has limited up side potential and limited risk. But, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade.
The maximum potential gain with this strategy is equal to the amount of premium received when the trade is opened. The maximum loss is equal to the difference between the exercise price of the options contracts less the premium received.
A Bear Call Spread in GIS
For GIS, we have a number of options available. Short term options allow us to trade frequently and potentially expand our account size quickly. Short term trades also reduce risk to some degree since there is less time for a news event to surprise traders.
In this case, we could sell an April 20 $50 call for about $1.50 and buy an April 20 $52.50 call for about $0.50. This trade generates a credit of $1.00, which is the difference in the amount of premium for the call that is sold and the call.
Since each contract covers 100 shares, opening this position results in immediate income of $1.00. The credit received when the trade is opened, $1.00 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $150. The risk is found by subtracting the difference in the strike prices ($250 or $2.50 times 100 since each contract covers 100 shares) and then subtracting the premium received ($1.00).
This trade offers a potential return of about 67% of the amount risked for a holding period that is about one month. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if GIS is below $50 when the options expire, a likely event given the stock’s trend.
Call spreads can be used to generate high returns on small amounts of capital several times a year, offering larger percentage gains for small investors willing to accept the risks of this strategy. Those risks, in dollar terms, are relatively small, about $150 for this trade in GIS.
These are the type of strategies that are explained and used in our TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your income and wealth building goals, click here for details on Options Insider.