When the economy struggles, markets go through specific, predictable cycles, leading to increased volatility and uncertainty amongst traders and investors. While some people see these as times to tighten up and focus on saving money instead of trading, many seasoned traders and investors view economic recessions as times when plenty of great trading opportunities can arise.
In this guide, we’ll focus on how recessions impact options prices and how traders can prepare for these market cycles. Understanding the effects of economic downturns on options is critical to positioning oneself effectively for both risk management and profit opportunities. By the time you’re done perusing our guide, you’ll know the indicators of an economic recession, the following cycles, and the critical strategies for thriving during these times. Keep reading to learn how to make the best of a bad situation and leverage things to your advantage despite the headwinds against you.
Understanding Economic Recessions and Market Cycles
Before we get into the fine details of trading strategies during economic recessions, we must first address what an economic slowdown is and prime indicators that signal the start of one during a typical market cycle. Though these are seen by many as a bad time to invest or trade, economic slowdowns still present some exciting opportunities for traders, but the strategies you end up using need to be appropriate to the moment that you’re at within the market cycle. This all comes into play when we begin discussing the finer points of options and strategies to use during recessions.
Definition of an Economic Recession
An economic recession is a significant and sustained decline in economic activity over a few months, which can be seen visibly in real income, employees, GDP, wholesale retail sales, etc. Recessions typically occur when consumer spending drops widely and can be triggered by a variety of events, like a supply shock, an economic bubble, or a financial crisis. Historical examples include the Recession of 1987 (Black Monday) and the Great Recession of 2008-09.
Phases of Market Cycles
With the signs of an impending economic recession in mind, let’s discuss the other market phases before and after the recession. It’s important for traders and investors to know how things will play out before the downturn hits and how the market ultimately recovers from a slowdown. We’ll discuss the five economic cycles below: expansion, peak, contraction (recession), trough, and recovery.
- Expansion: This phase occurs when the economy experiences growth over two or more consecutive quarters.
- Peak: This is the highest point of a business cycle, followed by the contraction period. The peak isn’t identified until after the contraction period has set in. The peak signifies when market growth has hit its maximum rate. During the peak phase of the market cycle, prices will stabilize for a short period, and during this time, businesses might reevaluate their budgets and spending. It’s the ideal time to do so because contractions usually follow peaks.
- Contraction: This is the phase when the recession hits. It’s characterized by falling employment rates, stagnant prices, and a slowdown in business growth. During this period, companies cut back on production to accommodate an economic slowdown and avoid being hung on a surplus supply. Contraction in a recession can continue to the point of a depression if it isn’t addressed.
- Trough: This phase of the cycle is the opposite of the peak. The trough is the point in the contraction period where the economy hits its ultimate low point. Like the peak, this is a time when businesses can evaluate their budgets and spending in anticipation of a market recovery.
- Recovery: This phase is when the economy goes on the upswing following the economic trough (the lowest point). The economy begins improving and healing from the damage caused by the recession. Typically, businesses will reallocate resources to new uses as growth comes back (production will ramp up to meet rising consumer demands). GDP and incomes will increase while unemployment falls.
Markets have relatively predictable board patterns like the cycles we just discussed, though there will be highs and lows during the economy’s rise or fall, which are much more difficult to predict. Markets might rise and fall while ultimately being in a contraction (downturn) or a recovery (upswing) pattern—the five cycles have a bit more nuance to them so that they will look a bit different each time the market changes trajectory.
Historical Examples of Recessions Impacting Markets
Throughout history, the United States has gone through several recessionary periods. In fact, the US has experienced 34 of these seasons since 1857! We could point to many examples, but we’ll look at two of the most recent and relevant examples to give you an idea of how each occurred and what ultimately happened.
The 2008 Financial Crisis
This severe economic downturn began in the United States in December 2007 and lasted until June 2009. It was caused by a wide range of factors, including low interest rates, risky mortgage products, loose lending standards, and (perhaps most significantly) the housing bubble bursting. During this time, unemployment peaked at 11%, US real GDP declined by 8.4%, home prices fell roughly 30%, and the S&P 500 fell by 57%.
The federal government and other regulatory agencies strongly responded to the 2008 Financial Crisis. Banks were required to reevaluate their funding sources and more closely assess the risk of their loans. The federal government ushered in the American Recovery and Reinvestment Act to expand safety nets for citizens and unemployment insurance.
COVID-19 Pandemic Recession
More recently, the two-month-long pandemic recession, which occurred in March 2020 and lasted until May 2020, resulted from the COVID-19 lockdowns that were put in place for fear of COVID-19 spread. The first signs of the recession happened in February and March when major indices dropped 20-30%. As a result of the lockdowns, there were more than 10 million unemployment claims by October 2020; there was a massive drop in oil prices, a downturn in consumer spending, and a collapse of the hospitality and tourism industries.
The first signs of recovery from this short recession occurred in April 2020 when the CARES Act passed. This was also when the recession hit the trough, and the markets began to enter the cycle’s recovery phase. As fears of the virus eased and states began opening up their economies for business, the overall economy began to recover, and by May, it was booming again.
How Economic Recessions Affect Options Pricing
Our entire guide is centered around how economic recessions affect options pricing, so this next section will discuss increased volatility, interest rate changes, and implied volatility. We’ll discuss how these factors ultimately impact option prices during a recessionary period in the economic cycle and what opportunities are presented to traders and investors as a result.
Increased Volatility and Its Impact on Options Premiums
An options premium is the total amount that a trader or investor pays for an option. When the economy takes a bad turn, prices on options trades can change drastically (volatility), and higher volatility leads to options prices rising (this applies to calls and puts alike). What this basically means is that it’s more expensive to trade, which leads many investors to become uncomfortable with buying stocks when the economy is bad.
There are several reasons why volatility spikes during recessions. When the economy is terrible, there’s a lot of uncertainty and fear, which results in traders performing market sell-offs. This higher implied volatility indicates that greater option price movement is expected in the future. Even though option premiums (the price that the consumer pays for each option) for both calls and puts increase during times of high volatility, history has shown that buying stocks during a downturn has been profitable for many traders.
It’s more expensive to trade options during a recession, and they’re prone to far more price swings than when fear and uncertainty aren’t major factors in trade decisions. However, traders and investors can use these price swings to their advantage. When investors get fearful and begin selling off shares, these are opportunities for those paying attention to get options at great prices!
Changes in Interest Rates and Their Effects on Options
Central banks often lower interest rates during recessions to stimulate the economy. Regarding options trading, interest rates (Rho) impact option prices by affecting the cost of carrying an investment in your portfolio. The general rule of thumb is that call options increase in value as interest rates increase, while put options decrease. This makes some options more desirable to buy or sell during times when the interest rates change.
- Call Options: Call options increase in value as interest rates increase. This is because the money used to buy the stock becomes more expensive.
- Put Options: On the other hand, an increase in interest rates leads to a decrease in the value of put options. The cost of carrying a short position becomes much more expensive, positively affecting put options during an economic downturn when interest rates increase.
- Long-Term Options: When interest rate changes occur, longer-term options are more sensitive to these changes than their near-term peers.
Ultimately, put options are the instruments that perform best during a recession because their value increases when central bankers lower interest rates to deal with economic contraction. Selling call options can also be favorable for traders or investors, but only if they believe interest rates won’t increase significantly. On the flip side of the coin, investors can also speculate on rising interest rates by buying call options and earning a profit if the interest rates rise by the expiration date.
Impact on Implied Volatility (IV) and Skew
Implied volatility (IV) estimates how much the market expects the price of an asset to change over a given period of time. Not only can implied volatility increase before a significant event or announcement, but it can also increase across markets during a recession or severe economic downturn. IV rises when the economy is bad because of uncertainty and concern about potential risks.
When options markets experience a downtrend due to faltering economic conditions, implied volatility increases. The market has been known to decline quickly following a large number of sell orders from fearful investors and traders.
The volatility skew is the difference in implied volatility between out-of-the-money options, at-the-money options, and in-the-money options. It basically describes the truth that not all options on the same underlying asset and expiration have the same implied volatility. The skew ultimately affects the supply and demand relationships between specific market options and market sentiment.
Out-of-the-money typically increases demand when the economy is in a recession, ultimately affecting options prices. OTM options have an unfavorable current market price of the underlying asset compared to the strike price. They’re less expensive than in-the-money options, but they’re also far less profitable (or worthless) because the market price does not justify the trader even exercising the option.
Key Strategies to Prepare for Market Cycles
In preparation for a brutal economic downturn, traders and investors would benefit significantly from developing strategies and techniques that hedge risk and keep their capital intact through smart trade decisions. We’ve outlined several strategies for dealing with a contracting market ready to head into a recession.
Adjusting Your Risk Management Plan
Traders should continually review and update stop-loss orders and portfolio exposure during a downturn. As the market conditions change for the better or worse, traders should adjust their current limits and strategies accordingly. For instance, an investor’s tolerance for risk might decrease as the economy worsens, so they might adjust their stop-loss limits, which would sell off losing positions more quickly.
Several proven options strategies are designed to hedge against market volatility. Part of effectively adjusting your risk management plan is using these strategies and techniques when they’re appropriate to thrive in options trading during tough economic times.
Focus on Hedging Strategies
Hedging strategies are risk management techniques that can reduce the risk of loss in online options trades. Traders and investors can employ these strategies by either diversifying their investments across different asset classes or taking the opposite position in a related asset.
Protective Puts
These are risk management strategies where traders or investors protect against losses in a stock by buying put options on a stock they already own. It’s done on a share-by-share basis. In the event that the stock price declines, the protective put will shield the investor against losses, but it will let their capital appreciate if the stock’s value increases. The only cost of a protective put is the option’s premium.
When there’s an economic downturn, investing in long positions is ideal. Traders can do this by buying the long position, buying a long put option for the same amount of stock, and choosing a strike price close to the current price. If the underlying asset increases in price from the purchase, the protective put can secure the trader a profit, so long as it is placed above the original purchase price.
Collars
Collars, or a collar position, are created when a trader or investor holds an underlying stock and simultaneously buys an out-of-the-money put option and sells an out-of-the-money call option. For a simpler understanding, a collar is a combination of a covered call and a protective put. Collars are a great hedging strategy for underlying assets in long positions when investors can be protected from short-term downside risk.
Using a collar, income is produced from selling the call option or up to the call’s strike price. This means the potential gains are relatively limited, even though the strategy is quite effective at protecting against significant losses. A trader’s best-case scenario in using a collar strategy is getting an underlying stock price equal to the strike price of the written call option when the expiration date is reached.
Volatility Spreads
Two primary hedging techniques fall under these “volatility spreads,” and they include straddles and strangles. These are two different strategies that are both decent for traders who hope to benefit from increased volatility during recessions.
Straddles
This neutral options strategy implies the expected trading range and volatility by the security’s expiration date. This technique is used when a trader simultaneously buys a put and a call option for the underlying security with the same strike price and expiration date. It’s only profitable when a stock rises or falls from the strike price by more than the premium paid by the traders or investors.
Straddles are best used when investing in highly volatile investments. When volatility increases, as it does during challenging economic times, options and straddle prices will increase, too. The long straddle, in particular, is best for traders who expect significant price changes but are uncertain of which direction it will go. If no strong price movements occur, the premiums from multiple options and securities will easily outdo any potential profit from the trade.
Strangles
Like the straddle we just addressed, strangles are an options strategy in which traders simultaneously buy or sell a call and put options with the same expiration date but a different strike price. The opportunity lies in implied volatility rising and increasing the value of options contracts, where a long strangle strategy can be employed.
The long strangle is ideal for investors who expect high volatility but are unsure of the direction—it pays off when the underlying asset moves strongly in either given direction. Strangles can be used by traders or investors to protect against severe downsides in the trade. A break-even point can occur in the event that the strangle generates a zero-dollar profit when it hits the stock price.
Capitalizing on Volatility
Volatility is a market factor that traders can take advantage of to make a profit, though many investors get scared when the outlook is bleak. They’ll begin selling off securities and positions in a panic. So, why is high volatility an opportunity for options traders? We’ll address the idea behind volatile market conditions and how traders can leverage high premiums in a recession to their advantage.
Selling Options
Check out a few successful ways of selling options while capitalizing on volatile market conditions:
Covered Calls
Covered calls are considered a neutral approach because the investor anticipates only slight increases or decreases in the underlying stock price. They’re best employed by investors who hold assets for a long period but hold a short-term view of the asset—this strategy involves earning a limited return for limited risk. When traders sell options using a covered call, they are selling an option on a stock they already own. Traders can generate minimal returns on the premiums received from selling the call option.
Covered calls are an investment strategy in which investors hold a long position in a stock and sell (write) call options on the same stock. Because the investor is “covered” (owning the stock), they are protected if the stock price increases and the call option expires in the money. This move is best in flat or moderately bullish markets, so it can be a good strategy when the economy is on the mend following the trough.
Naked Puts
In this options trading strategy, investors will sell a put option without owning the underlying asset to profit off the premium they get from selling it. Naked puts come with a maximum profit of the premium from selling the put option and a break-even point of the strike price plus the premium received.
Risks With Selling Options During a Recession
Selling options when the economy is bad or in any volatile market carries risk, and it’s important for investors or traders to know these risks to determine the right time to implement these strategies and techniques for maximum effect.
- Naked puts involve the seller being obligated to buy the underlying asset at the strike price if the option is exercised. However, this risk is relatively tame because the underlying asset can only drop to zero.
- There are far more risks with covered calls. An increase in the stock price can create a loss opportunity. Traders might owe taxes on any profit made from selling the stock or security. Contracts that end in the money can force investors or traders to sell their underlying positions at any time before the expiration date.
What to Watch for During a Recession
Leading up to and during a recession, traders and investors alike will want to monitor specific economic indicators to help inform their options trading decisions. Identifying company-specific risks in the process is critical to understanding the most viable trades in uncertain conditions. We’ll also address the pivotal role that central bank policies and government intervention play during a period of economic downturn and how that relates to options trading.
Key Economic Indicators to Monitor
The key indicators we’ll address here can be used to determine if a recession is on the horizon and to discover if the economy is on its way to recovery. Again, you must refer back to the market cycles we discussed earlier (expansion, peak, contraction, trough, and recovery) for this to make sense. These economic indicators influence market sentiment and options pricing in a major way, no matter where the economy is sitting, be it bust or boom.
Monitor these indicators to determine where the economy may be in the grand cycle. However, because this guide is about recessions, we’ll discuss these indicators and how they point to a possible recession. The opposite conditions indicate a recovery is soon to follow!
- GDP Contraction: A decline in real GDP for six months (two consecutive quarters) is a key indicator of the economy’s health, and it’s the common definition of an economic recession.
- Rising Unemployment: During recessions, the demand for goods and services falls, leading to company layoffs in an attempt to cut costs. As the economy worsens, the cycle continues, with decreased demand leading to even more layoffs and a higher unemployment rate.
- Reduced Consumer Spending: Less so than GDP contraction or rising unemployment, reduced consumer spending might indicate an economic recession. As consumers tighten their spending habits, a weakening economy could emerge, which will go hand in hand with a decreased demand for goods and services.
- Declining Consumer Confidence: The Consumer Confidence Index (CCI) is a survey that shows how optimistic or pessimistic consumers are about their personal financial situation and the economy in general. Consumers who are more pessimistic tend to spend less, which could be a good indication of a current recession or a looming one.
- Industrial Production: This metric measures the growth of manufacturing and utility industries, the foundations of an economy, and can indicate a recession on the horizon. Companies usually cut back on production when the economy takes a turn to minimize risk, so a decline in industrial production is usually a telling sign.
- Inverted Yield Curve: This happens when short-term interest rates are higher than long-term interest rates. It shows that investors aren’t optimistic about the economy and want higher yields on short-term investments (longer-term debt should have higher interest rates to compensate for greater risk).
- Inflation: Inflation leads to higher prices in business and borrowing—a key indicator of an impending recession. As inflation grows, businesses will raise prices or reduce production to cope, while banks might raise interest rates, which leads to a higher cost to borrow money. In turn, businesses and consumers will spend less. Inflation also leads to higher unemployment and fewer jobs in the economy.
- Retail Sales: If retail sales are up, it shows that consumers have money and are spending it, in other words, a healthy economy. On the other hand, slower retail sales are a good sign of economic recession because consumers aren’t willing to spend as much, or their money isn’t carrying them as far as it once did due to inflation.
- Real Income: In recessions where inflation is a primary driver, a consumer’s “real income” refers to that person’s purchasing power after adjusting their income for inflation. Suppose spending slows because consumers buy fewer goods and services because their money has less purchasing power. In that case, real money can be a crucial indicator of a recession brewing.
Company-Specific Risk
Not only do good traders want to monitor the current economic conditions they’re trading in, but they also want to research the companies they’re investing in to ensure they’re making healthy trade decisions. The potential for increased risk rises when companies come up against hard times and deliver dismal earnings reports or are considering drastic actions like bankruptcies. Your trade decisions are ultimately only as good and healthy as the companies you’re investing in, and some companies are much better at weathering the storms than others.
Let’s look at some of the universal risks that all individual stocks face, regardless of the business:
- Pricing Risk: Companies and businesses run the risk of their sales slowing down due to price increases, which cause consumers to slow down their spending. Though they can benefit when prices are higher, they can lose out on sales volume as consumers are less likely to go out and buy.
- Model Risk: Businesses that depend on economic models for success could be hurt if the models or forecasts are incorrect. Investors and traders run the risk of buying stock in a company that’s following an inaccurate business model, which will eventually hurt them financially.
- Headline Risk: Bad things that happen to a company can make their way onto the news and be talked about by media outlets, which can lead to market backlash. Sales and business can dry up quickly from a few bad headlines, and all companies can be prone to this “headline risk.”
- Risk of Detection: If a business or company isn’t operating honestly and employing corrupt business practices, there’s the chance that oversight bodies haven’t detected what’s going on, so traders risk investing in a company or business with a dirty secret. These investments will go belly up when the news breaks about what’s happened.
- Rating Risk: Poor analyst or credit ratings can cause major market swings in companies’ stock prices. Credit ratings can affect the price a business is willing to pay for financing, while analyst ratings can negatively impact the perception of the stock.
- Risk of Obsolescence: Any company or business could be replaced by a more successful business that can offer the same product for a better price. Companies that struggle to adapt to changing times run the risk of enduring financial hardships or possibly going bankrupt.
- Legislative Risk: New regulations or taxes can adversely affect businesses or companies that are trying their best to succeed but are burdened with red tape and bureaucracy. This can lead to companies with a lot more legislative risk than is really necessary, which can become a vulnerability in the company’s stock.
- Interest Rate Risk: When interest rates increase, it becomes harder for companies to stay in business because financing becomes more costly. In some cases, interest rates will rise to fight inflation, so companies might see their cost of funding going higher while the value of the money they’re earning is decreasing. Traders risk investing in companies that don’t have a good game plan to stay ahead of interest rate hikes.
After examining the risk specific to each company you’re investing in or trading options in, you’ll have to assess which hedging strategies or options selling techniques are best suited for the stocks of companies particularly vulnerable during economic downturns. Each situation is unique and will require a different approach.
Central Bank Policies and Government Interventions
As much as we’d like to think that the government works for the public’s general welfare all the time, some mixed results come from the monetary and fiscal policies that the central bankers and other government entities institute. Some help tremendously, while some do more harm than good. Central bankers or government intervention during recessions has been a mixed bag, sometimes exacerbating or alleviating recessions.
A few examples of actions taken by the Federal Reserve to fight a recession include:
- Lowering interest rates
- Quantitative easing (the Fed purchased additional assets)
- Making loans to financial institutions that are in trouble
- Buying assets directly from struggling financial institutions
- Increasing the money supply (open market operations)
While these actions on the part of the Fed can lead to lower interest rates and borrowing costs, they can ultimately lead to options prices increasing or decreasing in value. Call options decrease in value with a decrease in interest rate, while put options will increase in value following decreased rates.
Long-Term View: Recessions as Part of a Market Cycle
Recessions present opportunities for traders to build long-term positions by investing in put options due to downturns being prime moments to investors and traders to harness the power of cost-effective positions with longer expirations periods.
Using Recessions to Build Long-Term Positions
Suppose you’re a trader who doesn’t see a recession as a time to quit trading temporarily or tighten up your investments. In that case, you’ll view recessions and other hard financial times as opportunities to build long-term options positions, particularly LEAPS (Long-term Equity Anticipation Securities). Downturns can be the best time to acquire longer-term options at attractive prices. Buying LEAPS on a long-term index fund can be a good strategy for hedging against a recession or a significant market correction.
The Benefits of Long-Term Positions
- These investments have longer expiration dates, giving your hedge longer to perform its necessary functions.
- The cost-effectiveness of buying puts when you’re concerned about a potential market downturn (you still maintain equity positions).
- These long-term positions also allow investors flexibility in setting the strike price or expiration date.
- Investors can control a more significant portion of the index for a smaller upfront cost (increased leverage).
Long-Term Positions Aren’t without Their Risks
- Investing inputs means your capital could be tied up when you need it for trade opportunities, when the economy improves.
- Puts may expire as worthless if the economy improves and the market rises consistently.
- If the market doesn’t decline significantly before LEAPS’ expiration date, traders stand to lose their entire investments in the puts.
- If the market doesn’t decline as expected, the premium on the put options can erode—this is in addition to the high cost of the put options if market volatility is elevated.
Patience and Timing
Amid recessionary periods, traders and investors must keep patient when trading long-term positions in the hopes of future gains when the market begins to recover—avoiding emotional, panic-driven trades where fear plays a significant role in your decision-making. Keep a rational frame of mind and continue vital research on the companies you invest in and the positions you choose for your portfolio.
Timing is also crucial when investing in put options during a recession. You must wait for the correct entry points to take advantage of options trades that do well in a faltering economy. A few other scenarios where timing is everything: premiums on puts can erode if the market doesn’t decline as expected, puts might expire as worthless if the market begins recovery, and your capital could be tied up in put investments when it could be going to other trading opportunities.
View Recessions as an Opportunity
Something that separates good traders from traders who throw in the towel too easily is their view of hard economic times as prime opportunities for trading and investments. These traders see the silver lining in gloomy circumstances and find a way to make these conditions work to their benefit.
Recessions ultimately affect options pricing. During these hard times, central banks lower interest rates, which creates favorable conditions for investing in put options. Fear of volatile conditions causes many traders to begin selling off their options, which is also a prime time for getting options for a good price.
Along with seeking out trading opportunities when the economy goes bust, traders must use strategic planning during economic downturns, including risk management and hedging techniques like volatility spreads, protective puts, and collars. Remember that recessions are opportunities rather than periods of fear, offering both risks and potential rewards for those who prepare well.
