Lurking inside every stock market trade is the possibility for a sharp drop in price mirrored by the possibility for a fast price increase.

This risk vs. reward is a volatile dynamic retail traders must face each day.

And it is that very volatility – sudden price changes – that creates potential for profitable trades.

This week the stock market has been winding up for a likely volatile move based on the actions of the central bank. Pent up volatility is set to be unleashed tomorrow afternoon.

Major indexes close January at strong levels

A strong January for the stock market and positive corporate earnings reports on the last day of the month propelled the three major indexes to another winning session today.

In the market today, the Dow spiked to 34,086.04 points to gain 1.09% (adding 368.95 points on the day). The Nasdaq rallied higher to 11,584.55 points for a 1.67% jump while the S&P 500 also rallied by 1.46% to 4,076.60 points.

This was the best January for the S&P 500 in four years. It’s too soon to tell if the early rally is too bullish too soon.

Positive earnings reports were dulled by lowered revenue expectations and announcements of more layoffs in the technology sector. And the upcoming central bank rate hike announcement Wednesday afternoon could change market trajectory.

“It doesn’t do well to try to lay out a real specific plan in front of the volatility that certainly has the ability to show itself this week,” said Neil Yeager, Futures and Training Room Content Provider at Simpler Trading.

Volatile trading week can limit opportunities

However the Fed action plays out, the stock market still faces more economic news through the end of the week.

“I anticipate a wild and busy week this week given the amount of econ data and earnings that lie immediately ahead,” Neil said.

Notable earnings reports this week include Meta Platforms, Inc. (META) after the close on Wednesday and Amazon.com, Inc. (AMZN), Apple, Inc. (AAPL), and Alphabet, Inc. (GOOGL) will report after the closing bell on Thursday.

Nested amidst earnings are the December Job Openings and Labor Turnover Survey (JOLTS) on Wednesday which is closely watched by the Federal Reserve (Fed).

Traders should have eyes on the expected .25 percent increase in interest rates along with Fed Chairman Jerome Powell’s comments at his press conference Wednesday afternoon. Fed leaders last week indicated interest in keeping the interest rate hike below the previously expected .50 percent increase.

Traders need to do a little soul searching for how they work the market as all these news events unfold.

“Anything could happen,” Neil said. “It seems like everything they could throw at us is coming this week.”

Such a cycle of economic news in a short time frame can limit trading opportunities.

“It doesn’t do well to try to lay out a real specific plan in front of the volatility that certainly has the ability to show itself this week,” Neil said. “Be careful this week. Be patient.”

Fed holds psychological sway over market

The Fed has wielded a psychological influence over the stock market and retail traders for the better part of a year.

While some have struggled under this up-and-down influence, members of the Simpler Trading team have managed profitable trades.

Targeting market volatility with proven trade setups has proven successful for Allison Ostrander, Director of Risk Tolerance and an options trader at Simpler Trading. Allison has depended on the compound butterfly spread strategy for her ongoing trading strategy.

The uncertainty for traders is not knowing how the market will react – up or down – when the Fed announces its latest federal funds rate hike tomorrow afternoon.

“Sometimes using this strategy it actually gives me the flexibility to take profits on both sides (of a Fed event),” Allison said.

In volatile conditions like this week, Allison looks for opportunities to use the compound butterfly spread strategy, particularly call and put broken wing butterfly setups.

Traders use a butterfly spread in volatility because it is a neutral strategy that involves buying and selling stock options with different strike prices and the same expiration date. The goal is to target profit potential within a narrow range of prices.

This week Allison is looking for setups that could combine two debit style broken wing butterfly setups – one on the call side and one on the put side.

“The idea is that if we see volatility, whether up or down, there is a good probability that price will hit my strikes and I can lock in a profit covering the risk on the other side,” Allison said.

Compound butterfly strategy balances risk

With all the economic news events in play this week, no one knows exactly how the stock market will react to the Fed announcement on Wednesday afternoon.

“All I know is that there is a good chance for potential volatility,” Allison said.

That’s why she is focusing on the compound butterfly strategy that allows for the debit spread vs. credit spread within the setup. This allows for profit potential between the two sides of the trade.

For compound butterfly strategy trades this week, Allison will work to make sure the trade is executed before the Fed announcement and work to carry it through the end of the week.

As with all her trades, Allison is wary of the risk involved.

“The only thing that we can truly control is our capital risk,” Allison said. “We’ll be mindful of that as we set up trades.”

Allison’s compound butterfly strategy not only applies to economic and Fed news events, but it can be applied throughout the year where there is expected volatility. The key is to plan trades before the events happen.