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 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.)
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.
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.