The Impact of Economic Indicators on Options Prices

Have you ever wondered why a single economic report can send the options market into a frenzy? We have an answer to this important question. We’ll explore how key economic indicators influence options prices and how traders can use this information to their advantage. Understanding the relationship between economic indicators and options prices can help traders make more informed decisions.

Understanding Options Pricing Basics—The Key Components of Options Pricing

One of the critical concepts in options pricing is intrinsic value and time value. Both are used to determine options prices. An option’s total price (premium) is the aggregation of its intrinsic value and its extrinsic value (time value + implied volatility). Let’s get into the fine details of why both option pricing basics play a crucial role in understanding options trading and how economic factors impact investments.

Intrinsic Value

Traders use intrinsic value to their advantage when designing strategies that best suit their trading goals. It’s a key component in conducting practical fundamental analysis while assessing the pricing of options and other stocks. Intrinsic value helps traders know when to exercise options or adjust positions because it’s a metric that can be used to determine whether investments are overvalued or undervalued.

This is the difference between the strike and underlying asset prices. Intrinsic value is the perceived or true value of an asset. With intrinsic value, you subtract the current stock price from the strike price of a call option. You would subtract the strike price from the current stock price if it’s for a put option. Intrinsic value isn’t to be confused with the market price of an asset, which is determined by supply and demand.

Valuation models calculate an asset’s intrinsic value, taking into account factors like financial performance and cash flows. Investors can use a discounted cash flow analysis to determine a company’s or stock’s intrinsic value and discover the discount rate set by the Fed (short-term interest).

Time Value

This is based on the time remaining until expiration and volatility expectations—it’s the potential premium that investors might pay above the asset’s intrinsic value. Investors can calculate time value by subtracting the intrinsic value from the option’s premium. Time value is sometimes referred to as extrinsic value because it’s one of two components that make up the side of the option that’s not tied to intrinsic value. Time value and implied volatility make up the other half of the option, opposite the intrinsic value side.

In most cases, the more time that remains until the option expires, the better and higher the option’s time value. The less time remaining on an option, the less investors will pay the premium. Contracts with more time have longer to profit and are therefore appealing to investors who want to make some money over time. A good rule of thumb regarding an option devaluing with time is that it will lose about a third of its value in the first half of its life and then lose the remaining two-thirds in the second half.

A Quick Overview of Economic Indicators—What Are They?

Economic indicators are measures of economic activity that help investors, traders, and analysts understand the current economy and where it might be going in the future (they are typically macroeconomic measurements). You can access economic indicators in studies or data collected by schools, non-profit organizations, or the government. Once you understand where the economy stands and where it could be going, it’s easier to interpret current or future investments for your personal portfolio.

Leading Indicators

These metrics are used to predict an economy’s future movements. They’re called “leading indicators” because they move before an economic change occurs. These financial guideposts can help investors take action before significant market shakeups arise.

• Stock Market Returns: How the stock market is performing could reflect investor confidence regarding the direction of the economy. Reasonable stock prices reflect investors’ expectations about profitability—profits are directly linked to strong economic growth and activity.
• Consumer Confidence Index: This index surveys consumers on how they feel about current economic conditions and what they can expect from the future. It’s one of the more talked-about metrics regarding economic indicators, and it’s undoubtedly one of the more accurate ways to gauge where the economy could be heading.
• Yield Curve: Recessions and short-term market volatility can be detected using the yield curve, a leading indicator for many investors. Investors will examine the spread between two-year and ten-year treasury yields for an inverted yield curve, which might signal that a recession is imminent.
• Manufacturing Orders: Also called “durable goods orders,” are a monthly survey of manufacturers that measures industrial activity in the supply chain and durable goods sector. The US Census Bureau captures and produces this data.
• Initial Jobless Claims: The US Department of Labor generates a weekly report on the number of jobless claims filed for the week as an indicator of overall economic health. A weakening economy could negatively affect the stock market, and one of the strongest signs of slowing down is a rise in unemployment.
• Purchasing Managers’ Index: This metric gauges trends in the service and manufacturing sectors, indicating the growth of a nation’s gross domestic product (GDP). It reflects companies’ demand for specific materials.
• Company Performance: Further down on the list of economic indicators is perceived company performance as a result of customer complaints or negative feedback online, which could indicate a company’s direction if it is failing to satisfy customers with its goods or services.

Lagging Indicators

Lagging indicators confirm trends and changes in trends—they show up after a change in a business, the economy, or the financial sector. Lagging indicators trail the price action of underlying assets. Investors can use these indicators to either generate signals or confirm the strength of a current trend. In a way, they are the inverse of the leading indicators before the significant change. These result from the shift and signal the market trends moving forward.

• Unemployment Rate: Unemployment follows growth with a delay, and it’s considered a lagging indicator of economic activity. Jobless reports increase only when the downturn is prolonged.
• CPI Inflation: This lagging indicator is determined by comparing the average weighted cost of a basket of goods and services to the cost of the previous months and years. CPI inflation demonstrates that demand has increased due to economic growth or the opposite. Prices will rise to reflect demand.
• Balance of Trade (BOT): This metric measures the difference between a country’s imports and exports over a specific period of time. While it’s not enough to accurately assess an economy’s health, it’s still a helpful lagging indicator that indicates a major economic change.
• Interest Rates: These will change as a reaction to severe market movements, so they are a reliable lagging indicator that signals a significant change has occurred.

Coincident Indicators

Now that we’ve discussed leading and lagging indicators that bookend major market movements, let’s discuss coincident indicators and economic statistics that change in sync with the economy’s general state. These indicators provide information about the current situation investors might see in the overall economy. Due to the time it might take to collect and report this data, these indicators might not always reflect current conditions as much as they reflect recent conditions.

• Employment: If employment isn’t substantial, it signals less potential spending in the economy, and the assumption is that the slowdown will continue.
• Average Hours Worked (Manufacturing): This is one of the four state-level indicators comprising the State Coincident Index, along with payroll employment, the unemployment rate, and wage/salary disbursements.
• Personal Income: This refers to income people get from wages and salaries, interest, dividends, Social Security, business ownership, and other sources. Higher personal income rates are associated with strong economic growth, while lower personal incomes indicate faltering, sluggish economies.
• Retail Sales: Retail sales are a rough indicator of the current level of consumer demand and future economic activity. These figures capture a wide range of economic activity, such as apparel or home goods stores, gas stations, convenience stores, or furniture stores–making retail sales one of the most reliable coincident indicators.
• Gross Domestic Product: GDP moves in line with the overall economy because it gives investors a snapshot of how manufacturing at home has been doing in recent times.

Why Traders Care

Traders and investors must examine economic indicators if they want to successfully make their own forecasts and responsibly monitor financial market activity to promote their portfolio’s growth. These indicators (leading, lagging, and coincident) help forecast market conditions, influencing both stock and options prices. Investors can use these tools to anticipate the direction of the financial markets, and in the process, they gain insights that will help them make informed decisions that benefit them!

Key Economic Indicators that Impact Options Prices—The Most Important Reports to Watch

While we highlighted a wide range of leading, lagging, and coincident indicators in the previous sections of our guide, some reports are more important than others for options traders to monitor: the key economic indicators that ultimately impact the prices of options on the market.

Interest Rates (Fed Policy Decisions)

The general rule of thumb with interest rates is that lower rates make borrowing money cheaper for investors. This encourages consumer and business spending, which boosts stock prices and leads to increased investments. On the flip side, higher rates discourage consumers from spending money and can cause companies to deliver lackluster returns, souring stock prices as well.

• Impact on Options: How do higher or lower interest rates ultimately affect options trading? Higher rates typically lower stock prices, impacting options premiums. Increased interest rates are likely to drive up call premiums and ultimately cause put premiums to decrease.
• Real-World Example: When the Fed introduces an interest rate hike, they decrease the price of put options because the cost of carrying a short position becomes more expensive. With put option prices spiking, you’ll see investors selling off these options as they might be too costly to maintain. The higher the interest rates, the more slowdown you’ll see with options or stock trading.

Inflation Data (CPI and PPI Reports)

The CPI is the Consumer Price Index, which measures the total value of goods and services bought by consumers over a period of time. Government agencies consult the Consumer Price Index to make cost-of-living adjustments. These changes ultimately affect federal pensions, Social Security, lunch subsidies for schools, and others.

The PPI, the Producer Price Index, measures the average price change in domestic producers’ output. When prices rise, producers typically pass the costs to consumers, so the PPI is a leading indicator of the Consumer Price Index (CPI).

• Impact on Options: CPI and PPI are both used to measure price changes—higher PPI typically signals higher inflation. Rising inflation can cause higher volatility, increasing the time value of options. The amount of time premium that disappears from the option’s price per day increases as the expiration date draws nearer.
• Example: The relationship between inflationary pressures and increased call option premiums is pretty simple—higher interest rates can increase call options’ prices (the premium) because the money used to buy the stock becomes more expensive.

Unemployment Rate

As job growth slows down, the Federal Reserve typically lowers interest rates, resulting in higher stock prices. Conversely, in an environment with job growth and lower unemployment, the Fed raises interest rates, which can depress stock prices.

• Impact on Options: Falling unemployment can signal economic growth, boosting stock prices and making call options more expensive, and vice versa for increased unemployment. In some instances where unemployment is higher than usual, the Fed can lower interest rates, which raises the price of stocks.
• Real-World Example: Low unemployment data can be an indicator of an economy that is on the upswing which means there’s more money and a higher likelihood that investors will be spending on options, driving demand. On the flip side, bad unemployment numbers could cause investors to not want to take risks in options trading due to the economic downturn.

GDP Growth Reports

GDP stands for gross domestic product, and it’s one of the most popular and widely used indicators of economic activity and overall performance. It tracks the health of a country’s economy, measuring the total economic output during a given period. GDP is adjusted for inflation to measure changes in output and to eliminate quarterly variations based on holidays or adverse weather conditions.

• Impact on Options: Strong GDP growth may boost stock markets, pushing up call option prices. Strong GDP growth is an indicator of a strong economy, so earnings will be higher along with stock prices. Investors get excited when the GDP growth report signals a bullish period ahead. Options can be obtained for less money because stock prices are lower during these times.
• Example: When GDP growth beats expectations, it increases demand for bullish options. Corporate earnings are growing during this time, so investors are in a spot where they can pick up options for a better price, and there’s a significant demand for them. It’s a buyer’s market.

Consumer Confidence and Spending

Good retail sales numbers and a positive economic outlook on the part of the consumer are another indicator of a robust, growing economy. When consumer confidence is low and retail sales are down, it’s a good indication that the economy is on a downturn. When the outlook for the economy is optimistic, there will be more spending, which stimulates the economy.

• Impact on Options: High consumer confidence often correlates with rising stock prices, making options more valuable. Consumer confidence is defined as the degree of optimism about the state of the economy—consumers express their confidence in the economy through their spending and saving habits. When the economy is good, or the consumer perceives it as good, they’ll tend to purchase more options because they have more money to spend. The options tend to be more valuable in these economic conditions—they’re a good investment!
• Example: Spikes in consumer spending lead to higher demand for call options in retail stocks. When there’s a lot of consumer confidence and people have the money to spend due to favorable economic conditions, they’ll purchase retail stocks. The influx of sales will lead other investors to buy, driving demand for these options and positions.

Volatility and Economic Indicators—How Volatility Changes with Economic Data

Specific economic reports increase market volatility, affecting the implied volatility component of options pricing. We’ll highlight the primary volatility and financial indicators and how they can ultimately affect options trading by announcing economic data like employment numbers, retail sales, gross domestic product reports, etc.

Volatility Index (VIX) as a Gauge

Investors can use the VIX (Volatility Index) to track market sentiment and volatility expectations. It’s a way for investors to make more informed trading and investment decisions. The volatility index is calculated from the prices of SPX index options that have near-term expiration dates.

When interpreting VIX, several indicators can help you determine market sentiment and possibly how volatile the current environment is—remember that high volatility leads to investor uncertainty, and low volatility leads to investor confidence.

• 0-15 VIX: These are optimum conditions where investors have confidence in the market’s future.
• 15-25 VIX: There’s more volatility in this environment, but it’s not enough to make investors uncertain or antsy about the future of the market. There’s some volatility, but it’s no cause for concern at the moment.
• 25-30 VIX: At this point, volatility has increased significantly, and the market is becoming more turbulent. Investors are becoming more concerned for the future, and the market is becoming more unpredictable.
• 30+ VIX: The market becomes extremely volatile, and stock prices swing significantly. This uncertainty causes many investors to dump stocks that are losing value.

Pre- and Post-Report Volatility

Implied volatility indicates how the market sees the future changes in a security’s price. Volatility plays a factor leading to the announcement and immediately following. Earnings reports can usher in times of volatility as investors navigate the news of how truly profitable the company has been. As investors anticipate stock movement, the options’ prices might rise, though they tend to fall or even out after the announcement when there’s more certainty in the market again.

After a company releases an earnings report, share prices will increase or decrease based on the company’s recent performance. Investors will look to protect their capital or examine price swings to determine hot buys as other investors dump what they have—this all depends on whether the reports are good or bad for the future of that particular company.

Strategies for Trading Options Around Economic Reports—Practical Tips for Navigating Economic News

We have some practical tips for navigating economic news, such as earnings reports, inflation reports, GDP growth reports, and the like. Employ the following strategies to keep your options trading experience competitive. Introducing a mix of these strategies or techniques into your trading regimen can keep your portfolio well-balanced and your risk tolerance in an optimum place.

Use Calendar-Based Trading

Plan options include trading around key economic releases like earnings reports or job data using an economic calendar or a calendar spread strategy. In both cases, these tools track economic events that impact trading, but each approach has its own unique touch.

• Economic Calendar: These calendars include resources like central bank announcements, government reports, manufacturing indices, employment reports, or inflation data, which allow traders and investors to identify opportunities or risks within various financial markets. By tracking significant economic events and announcements, traders or investors can anticipate what the market might do in the future.
• Calendar Spread Strategy: Some investors refer to this strategy as a “horizontal spread,” a “time spread,” or an “interdelivery spread.” This involves buying a longer-dated option and simultaneously selling a shorter-dated option—both have the same strike price and type. Because these assets have stable prices, investors or traders can discover changes in implied volatility, giving them insight into markets following significant economic news!

Buy Options Ahead of Volatility

Consider buying options before a major economic report, especially if volatility is expected to rise. Gains can be quickly realized in earnings announcement trading, as the market volatility around earnings season can lead to significant price movements where investors gain opportunities to lock in a profit. The upside potential is unlimited, and the losses are limited to the option’s premium (when buying options). At the same time, the maximum profit is the premium received, and the downside potential is often unlimited (when selling options).

There are a few things you need to watch out for when buying options ahead of a volatile market. Significant price movements could lead to huge losses if the timing isn’t right—the market could always move against expectation, too. Because options are a decaying asset, losses can mount as quickly as gains are realized.

Consider Straddles or Strangles

Investors and traders use a volatility-neutral strategy to profit from significant price movements, regardless of direction, when using straddles or strangles. You can expect a significant price move in an underlying stock even if you aren’t confident of the price’s direction.

• Straddles: Buy and sell a call and put option for the same underlying security simultaneously (the expiration date and strike price are the same on each option). Best for high-volatility investments, straddles protect the investor from volatile market price movements.
• Strangles: Buy and sell a call and put option with the same expiration date but a different strike price. It’s best to use a strangle when expecting large price movements with underlying securities. Use long strangles when you anticipate the underlying asset moving aggressively by the expiration date and short strangles when you anticipate minimal movement in either direction of the underlying asset.

Let’s talk a bit more about straddles. Check out a few additional reasons why this might be the ideal strategy for trading around economic reports:

• Accuracy in your predictions or price forecasts doesn’t matter as much because straddles benefit from significant price movement for the expiration date.
• They profit from upward and downward price movements.
• With the maximum loss being limited to the premium paid, there’s little risk involved.
• Straddles don’t require as much upfront capital.
• Enjoy unlimited profits if the price moves favorably before the expiration date.

Post-Report Analysis

Traders or investors must thoroughly analyze various market reactions post-report to spot potential continuation or reversal opportunities. Continuation patterns are indications that a price trend is likely to continue as is, while reversals signal a significant shift away from the current trajectory.

Continuation Patterns

• Symmetrical Triangle—With two swing highs in price and two swing lows in price, symmetrical triangles are defined by a downward-sloping upper bound and upward-sloping lower bound in price.
• Ascending Triangle—A horizontal upper bound and an upward-sloping lower bound define this continuation pattern. Like symmetrical triangles, these come with two swing highs and two swing lows.
• Descending Triangle—A downward-sloping upper and horizontal lower bound indicates this pattern. The price action gets tighter as the price reaches the apex, and descending triangles are characterized by the classic two highs and two lows you see with the other triangle continuation patterns.
• Flags—These are typically short and don’t have price swings back and forth. The price becomes confined in a small price range between two parallel lines.
• Pennants—This continuation pattern emerges when prices converge and cover a small price range mid-trend.
• Rectangles—Known as trading ranges, rectangle patterns indicate sideways price action, which could take place over a short period of a few years. It’s not uncommon to see this continuation pattern briefly at any point during the day, but you most likely see it on a long-term basis.

Reversal Patterns

• Morning Star: This reversal pattern indicates that the bulls are going to take control of the market. You can count on it to be accurate and reliable when it appears.
• Engulfing Pattern: This reversal, which appears like two candlesticks on the charts, can signify a bullish or bearish environment is on its way.
• Head and Shoulders: This reversal appears like two smaller price movements around a larger one.
• Double Bottom: This reversal signals a short-term swing low. An attempt to break below the same support level follows, but it’s ultimately unsuccessful.
• Double Top: This one is similar in concept to the double bottom but indicates a short-term swing high, which is succeeded by an unsuccessful attempt to break above the same resistance level.
• Hammer: Under certain conditions, the hammer reversal delivers a bullish reversal, but not 100% of the time.
• Inverted Hammer: Following a solid downtrend, the inverted hammer is a bullish reversal candlestick pattern that indicates a possible uptrend.
• Falling Three Methods: This bearish reversal pattern suggests the market is about to take a downward turn.
• Shooting Star: This pattern emerged during an uptrend. It has a long upper shadow and a smaller lower body, taking the form of a shooting star (hence the name).
• Dark Cloud Cover: This pattern indicates a bearish reversal. It occurs when sellers have overtaken buyers in the market for three consecutive trading days or more.
• Hanging Man: A reversal pattern that indicates a market high; this one signals that the market is about to take a dip.

The Impact of an Economic Event on Options—Real-World Example

For this example, we’ll look at the Fed cutting interest rates to stimulate the economy in 2008 during the housing market crash. Let’s do a quick analysis of this historic Fed interest rate announcement to see how it ultimately affected options prices for major indices or stocks.

Housing Crash (2008)

During the housing market crash in 2008, the Fed introduced interest rate cuts to stimulate the economy. On January 22, they cut rates by 0.75% from 4.25% to 3.50% as an initial response. They cut rates again on January 30 by another 0.50-3.00%. Later that year, in October, the Fed cut rates from 2.00% to 1.50% following the bankruptcy announcement of Lehman Brothers.

Starting in December of that year, the Fed lowered rates to zero and kept them that way for six years, until December 2015. The central bank then began to carefully raise rates as the economy was on its way to recovery. They also started an asset purchase program, where they bought mortgage-backed securities and longer-term Treasury securities.

Lessons Learned

In options trading, the general rule of thumb is that call options increase as interest rates increase and put options decrease in value. During the global financial crisis, options trading strategies that bank on rising interest rates were rendered ineffective and irrelevant. 2008 to 2015 wasn’t an excellent time for trading options if you were expecting to take advantage of rising interest rates (they were at zero during that time).

Study Economic Indicators to Make Better Moves on Options

Understanding economic indicators can give traders an edge in the options market, especially when they have a good grasp on leading, lagging, and coincident indicators that can tell investors about the state of the current economy and what it might look like shortly. The more you can consider these events and announcements, the better informed your trades and investments will be! Incorporate economic indicators into your trading strategies and monitor the economic calendar for market-moving data.