Inflation Numbers and Options Trading

At the times when the Federal Reserve is raising or lowering interest rates, they are the major driver of the market. Fed actions can raise or lower stock prices depending on what they are doing to interest rates. Options traders can benefit from movements either up or down while at the same time leveraging trading capital and limiting risk. When the Fed is on the move adjusting rates the market pays attention to inflation numbers, the Fed’s pronouncement of any change in rates, and the publishing of the minutes of the Open Market Committee which sets rates. Understanding inflation numbers and options trading for profits are irreversibly intertwined.

How Inflation Affects Stocks

The direct effect of inflation on stocks is that the cost of doing business goes up (labor and materials) and if the company is unable to pass on those costs by raising their prices their profits fall followed by their stock prices. Then banks will raise interest rates making credit more expensive and when the Federal Reserve acts to fight inflation it raises interest rates even more, trims its balance sheet, and slows the economy which means less business comes in the door at the same time that profit per customer is suffering. Growth stocks tend to suffer worse than value stocks like consumer goods. In fact, as Fed actions bring on a recession consumer goods stocks may go up as they are doing better than riskier stocks and investors often pivot from growth to value until the recession starts to turn around.

What Do Inflation Numbers Tell Us?

The most popular measure of inflation is the CPI or cost of living index. The CPI measures monthly changes in what US consumers pay for goods and services. The Bureau of Labor Statistics produces a weighted calculation for the same basket of goods and services every month. The basket of goods and services is chosen to be a fair representation of US consumer spending in the aggregate. It is produced along with a companion index, the Producer Price Index which shows changes in prices that US producers receive for goods and services. When the CPI report comes out there is also a report for the index minus good and energy as these two factors tend to be the most volatile and thus may confuse the predictive power of the CPI numbers if it is not understood where price increases or decreases are coming from.

Data Driven Fed Decisions

The Federal Reserve has three mandates. They are to promote stable prices, maximum employment, and moderate long term interest rates. Generally this is considered a dual mandate because when they get employment and prices right interest rates typically take care of themselves. When the economy is out of kilter, such as when inflation is up the Fed follows data such as the CPI and employment numbers to determine whether or not to raise (or lower) interest rates which is their primary tool. Because the Fed Open Market Committee uses inflation numbers from the CPI and other sources to decide on rate adjustments the market reacts to CPI numbers in anticipation of the next Fed rate decision.

Market Reaction to Inflation Numbers

When the Fed lowers interest rates the eventual effect is to stimulate the economy and drive stock prices up and when they raise rates the effect is to slow the economy and drive stock prices down. When there is a clear move up or down in the CPI the market assumes a clear move by the Fed. At such time buying on the rumor and selling on the news is often a good plan. When a Fed decision could go either way a common approach is to use a straddle such as a long straddle in which the trader buys both puts and calls with the assumption that one or the other will generate a profit. As always at Top Gun Options when we use either of these approaches, we hedge our risk.