Shorting Volatility Around FOMC
Exploiting the FOMC Drift
Hi there. Today is FOMC day, with the rate decision due in about 15 minutes. Back in February, I wrote about the FOMC drift, a pattern where equities tend to drift upwards into scheduled Fed announcements, starting from the close two days prior. This anomaly was first documented over a decade ago and has since attracted both academic and practitioner attention. (See my earlier post for a discussion on related research.)
In that post, I demonstrated that the pattern has persisted despite being well-known. While it briefly faded during 2016–2017, it regained strength in subsequent years. The chart below, taken from my earlier post, shows the cumulative average return on SPY based on 1-minute data from two days before the FOMC announcement through the day after. The grey areas represent the first and second days of FOMC meetings.
The chart highlights a clear upward drift in equities leading into the FOMC announcement, beginning from the close two days prior. A straightforward strategy, buying at that close and exiting at the end of the FOMC day, has delivered an 8% CAGR and a Sharpe ratio of around 0.6 after costs, despite being active only about 6% of the time. Below are the corresponding results for the triple-leveraged ETF SPXL, as shown in my earlier post.
A likely explanation for this pattern, put forward in academic research, is the gradual resolution of uncertainty as the announcement approaches. As investors gain clarity on monetary policy, risk premiums tend to compress, lifting equity prices and reducing volatility in the process. Research also shows the effect is stronger during periods of high market volatility and weak economic growth.
If the core driver is indeed uncertainty resolution, a more direct way to capture this effect may be through shorting volatility. Instead of trading equities, I test strategies that go short volatility at the close two days before the FOMC announcement and exit at the close of the announcement day.
Specifically, I test two approaches of shorting volatility and find that both methods deliver even stronger performance than the equity-based strategy. More details below.