Most option trades, even many non-directional strategies, are impacted by economic factors. At the least, macro factors influence the stock price. Options traders should have a good knowledge of the market, and, even better, should at least use a few tools to develop a view on how the market is likely to act in the future. With so much information available, this can sometimes be overwhelming. One of the ways for options traders to gauge the market direction is with the help of key economic indicators. (For related reading, see Economic Indicators For The Do-It-Yourself Investor.)
TUTORIAL: Economic Indicators

What are economic indicators? In simple terms, an economic indicator is a statistic typically published by the government that tells the current state of the economy. While some indicators are lagging, we prefer "leading" indicators that tend to be predictive. Since a country's financial markets are directly linked to its economic conditions, these economic indicators can tell a lot about the direction the markets will take in the near future. (For related reading, see Leading Economic Indicators Predict Market Trends.)

Having a good knowledge of these economic indicators provides the traders a guide as to where a certain option is heading to, if it is in an upward or downward direction. A trader can use numerous economic indicators while trading options.

The traders can combine the knowledge of these broad market indicators along with the other specific technical indicators to help predict market movement. For example, in a bullish market, they have an idea of how high the security prices will go and the expected timeframe in which this will occur, in order to form an optimal trading strategy. Similarly, in a bearish market, they have an idea of how low the security prices will go and the expected timeframe in which this will occur.

In this article, we will discuss the six important economic indicators, namely, consumer price index (CPI), gross domestic product (GDP), trade balance report, money supply, unemployment rate and credit markets. Let's now look at each of these indicators in detail. (For related reading, see What Are Leading, Lagging and Coincident Indicators? What Are They For?)

Consumer Price Index
The CPI measures the average change over time in the prices paid by consumers for goods and services. It is the most widely used measure of consumer price inflation. In principle, the stock markets perform well when there is strong economic growth and low inflation. High inflation adversely affects the performance of companies, which in turn affects the stock prices. High inflation also leads to a rise in interest rates, which can adversely affect investments in the stock market. One reason is because in a high interest rate environment bond prices fall and the bond markets are seen as a cheaper investment option compared to stock markets. (To learn more, see How Interest Rates Affect The U.S. Markets.)

Gross Domestic Product
GDP is the total value of all the goods and services produced over a specific period of time. It is a primary indicator of the growth or contraction of the economy. GDP is announced quarterly and it can significantly impact the markets. Positive GDP indicates that the economy is growing, profits are rising for companies and, therefore, boosts the confidence of investors. Negative GDP indicates that the economy is contracting, wherein the overall spending in the economy reduces, the companies' profits reduce and the stock markets are adversely affected. (For related reading, see The Importance Of Inflation And GDP.)

Trade Balance Report
The trade balance report, released every month by the Bureau of Economic Analysis, provides useful information to the investors and helps them understand the health of the economy. The report determines the overall standing of the country's economy against other world economies. The most important parameter in the trade balance report is the trade deficit, i.e., the dollar value of exports minus the dollar value of imports. Another important parameter is the current account deficit. The U.S. economy has been running a trade deficit and current account deficit for many years. This is mainly because the U.S. demand for goods is higher than other countries. For instance, for the markets to do well, the investors will expect the trade balance to maintain the current level or to fall, which will indicate rising exports.

Money Supply
Money supply is the amount of money available for spending in an economy. The money supply movements are treated as a key indicator for predicting the future movement of stock prices. In the U.S., the Federal Reserve Bank (Fed) controls the supply of money using open market operations. The Fed also controls the short-term interest rates, called the Fed Fund rate, which affects the money supply with time lag. A tightening monetary policy is associated with falling stock prices, while a loosening monetary policy is associated with rising stock prices. When the Fed tightens the monetary policy, it leads investors to perceive stocks as being a riskier investment and thus demand higher returns. Given the same expected dividends, the higher return is achieved by a fall in stock prices. Similarly, a loosening monetary policy leads to a rise in stock prices.

A growth in money supply also indicates that inflation will increase soon. The combined knowledge of GDP and money supply growth can tell a lot about future trends in the economy. If the money supply is growing faster than the economy (indicated by GDP), then there is too much money chasing less goods and services, which will lead to inflation. (Find out how the Fed manages bank reserves and how this contributes to a stable economy. For more, see How The Federal Reserve Manages Money Supply.)

Unemployment Rate
The unemployment rate represents the fraction of the labor force that is unemployed. The unemployment rate, published by the Bureau of Labor Statistics every month, is a lagging indicator of the economic and stock market health of a country. A rising unemployment rate is considered favorable for bond markets. Its effect on the stock markets is a bit ambiguous. First, a low unemployment rate signals a strong economy and higher profits for corporations. Second, lower unemployment rates may increase inflation, which leads to higher interest rates and is considered troublesome for the stock market. Third, lower unemployment rates also tend to increase wage inflation. High wage inflation has a bearish affect on the stock market, because higher wages will reduce company profits and result in a fall in stock prices. To fully understand the impact of the unemployment rate on stock markets, it needs to be viewed along with the current state of the economy. If the economy is expanding (positive GDP), a rise in unemployment is considered "good news" for the stock markets. On the other hand, if the economy is contracting (negative GDP), it is considered "bad news" for the stock markets.

Credit Market
An analysis of the credit markets can also tell a lot about the stock market movements. One of the important measures of the stress on credit markets is the TED (acronym formed by combining T-Bill and ED, the ticker symbol for the eurodollar futures contract) spread. The TED spread is the interest rate differential between the LIBOR and the U.S. T-Bill rate; it is an indicator of the perceived credit risk in the economy and is generally between 10 and 50 basis points. A rising TED spread indicates that the banks are reluctant to lend to each other due to increased credit risk. A rising TED spread, therefore, indicates tightening credit markets, reduced liquidity in the market and signals a downturn in stock markets. (For related reading, see 5 Signs Of A Credit Crisis.)

The Bottom Line
There is a wide array of economic indicators that can be used by options traders; the indicators discussed above are the most popular. These key economic indicators help options traders predict the market movement and arrive at trading strategies by combining them with fundamental and technical analysis.

Related Articles
  1. Economics

    The Unemployment Rate: Get Real

    Depending on how it's measured, the unemployment rate is open to interpretation. Learn how to find the real rate.
  2. Options & Futures

    The Consumer Price Index: A Friend To Investors

    As a measure of inflation, this index can help you make key financial decisions.
  3. Forex Education

    5 Reports That Affect The U.S. Dollar

    These five reports provide short- and long-term insight into the valuation of the U.S. dollar.
  4. Fundamental Analysis

    Can Global Investors Profit From GDP Watching?

    GDP growth is not necessarily a solid indicator of stock market returns in emerging markets. Find out what to watch instead.
  5. Budgeting

    Current Account Deficits: Government Investment Or Irresponsibility?

    Deficit can be a sign of trouble for some countries, and of health for others. Find out what it means when more funds are exiting than entering a nation.
  6. Bonds & Fixed Income

    How To Use Gross National Product As An Indicator

    Learn what the GNP truly represents, and how its misuse can manipulate the facts.
  7. Economics

    What Qualifies as Full Employment?

    Full employment is an economic term describing a situation where all available labor resources are being utilized to their highest extent.
  8. Fundamental Analysis

    Is India the Next Emerging Markets Superstar?

    With a shift towards manufacturing and services, India could be the next emerging market superstar. Here, we provide a detailed breakdown of its GDP.
  9. Investing News

    Timing of the Fed Interest Rates Hike

    Until the beginning of August, Fed watchers expected the central bank to raise rates in September. However, recent news pertaining to China’s slowing economy and its devaluation of the yuan have ...
  10. Mutual Funds & ETFs

    ETF Analysis: ETFS Physical Platinum

    Learn about the physical platinum ETF. Platinum embarked on a bull market from 2001 to 2011, climbing to record prices along with other precious metals.
RELATED TERMS
  1. Derivative

    A security with a price that is dependent upon or derived from ...
  2. Cost, Insurance and Freight - CIF

    A trade term requiring the seller to arrange for the carriage ...
  3. Security

    A financial instrument that represents an ownership position ...
  4. Series 6

    A securities license entitling the holder to register as a limited ...
  5. International Monetary Fund - IMF

    An international organization created for the purpose of standardizing ...
  6. Inflation

    The rate at which the general level of prices for goods and services ...
RELATED FAQS
  1. Is Argentina a developed country?

    Argentina is not a developed country. It has one of the strongest economies in South America or Central America and ranks ... Read Full Answer >>
  2. How is the Federal Reserve audited?

    Contrary to conventional wisdom, the Federal Reserve is extensively audited. Politicians on the left and right of a populist ... Read Full Answer >>
  3. Is Brazil a developed country?

    Brazil is not a developed country. Though it has the largest economy in South America or Central America, Brazil is still ... Read Full Answer >>
  4. Who decides when to print money in the US?

    The U.S. Treasury decides to print money in the United States as it owns and operates printing presses. However, the Federal ... Read Full Answer >>
  5. Are Social Security payments included in the US GDP calculation?

    Social Security payments are not included in the U.S. definition of the gross domestic product (GDP). Transfer Payments For ... Read Full Answer >>
  6. Why do some people claim the Federal Reserve is unconstitutional?

    The U.S. Constitution does not mention the need for a central bank, nor does it explicitly grant the government the power ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!