Basic Economic Analysis

In this article, option traders will learn how to :

  • Conduct basic economic analysis before making trades
  • Rely on factors to predict broad market movements
  • Gauge the macro direction of the economy

Interest rates

Interest rates represents the cost of borrowing money within the economy. If interest rates rise, the cost of borrowing increases. As a result, capital expenditures in companies will decrease. Over time, this means that the companies will earn less with smaller capital expenditures. Capital expenditures are really investments for the future. For example, a company in the oil and gas sector that does exploration and production requires rigs in order to extract the natural resource. A fall in capital expenditures preceded by a high cost of borrowing(hike in interest rates) will cause potential profits to decline.

In general, one can expect the price of stocks and bonds to go down when interest rates go up.

If interest rates fall, the prices of stocks and bonds will go up.

The relationship between interest rates, bond prices and stock prices can be summarised in the table below.

Interest rates Bond prices Share prices
Up Down Down
Down Up Up
Sideways Sideways Up

Inflation

There are 2 ways to measure inflation. Inflation can be measured with the consumer price index or the producer price index.

The consumer price index is a measure of prices of consumable goods and services.

The producer price index is a measure of change in prices of domestic goods created by producers.

For example, the US dollar is weak relative to other currencies, it causes import prices to rise. This may cause inflation.

If the Consumer Price Index and the Producer Price Index goes down, one can expect bonds and stocks to react positively by going up.

If the Consumer Price Index and the Producer Price Index goes up, one can expect bonds and stocks to go down.

Employment

The unemployment rate is an indicator that helps to forecast and predict the direction of the economy.

When the unemployment rate is up, the stock and bond markets will go up.

When the unemployment rate is down, the stock and bond markets move down.

While this may be hard to comprehend, contrarians who are forward looking understand this indicator very well. A high unemployment rate means that the economy is not doing as well. As a result, contrarian investors will buy into those markets then.

You can use these indicators to determine your trading decisions. For example, if the economy is doing well or about to turn around from a recession, coupled with a stock’s good fundamentals and technical charts, an investor may want to initiate a long position in a call to capture the upside of the potential price move.

Summary

An options trader should rely on these indicators to determine the general direction of the economy before making a trade. For example, the trader may be bullish on a particular company’s stock but the stock market is heading into a recession. A recession will cause stock prices to decrease in general. Hence, the options trader may wish to rethink his decision to make the trade. Even if corporate earnings are not outstanding but economic growth is steady, stock prices can still rise. Case in point can be summarised in one quote: “A rising tide lifts all boats.” Of course, the opposite is also true as well. Option traders should conduct some form of economic analysis to know the general market direction.

Read: Fundamental Analysis

Case Study On Economic Analysis: Fed Rate Hike Or Interest Rate Hike