How Does Basic Macroeconomics Impact Trading?

Investing in stocks and options can be a rewarding venture, but it is not without its challenges. Understanding the macro factors that influence these markets is crucial for making informed decisions. In this post, we will explore the various economic, political, and social factors that can impact stock and options trading, providing you with the insights needed to navigate these complex waters.

A bustling stock market trading floor filled with activity.

Economic Indicators

Economic indicators are statistics that provide insight into the overall health of the economy. They can significantly influence stock and options trading. Here are some key indicators to watch:

Gross Domestic Product (GDP)

GDP measures the total value of goods and services produced in a country. A growing GDP often signals a healthy economy, which can lead to increased investor confidence and higher stock prices. Conversely, a declining GDP may prompt investors to sell off stocks, leading to lower prices.

Unemployment Rate

The unemployment rate is another critical indicator. High unemployment can lead to decreased consumer spending, which negatively impacts corporate earnings and stock prices. On the other hand, a low unemployment rate typically indicates a robust economy, encouraging investment.

Inflation Rates

Inflation affects purchasing power and can influence interest rates. Central banks may raise interest rates to combat high inflation, which can lead to decreased borrowing and spending. This scenario often results in lower stock prices as companies face higher costs and reduced consumer demand.

Interest Rates

Interest rates set by central banks can have a profound impact on stock and options trading. Lower interest rates make borrowing cheaper, encouraging businesses to invest and consumers to spend. This can lead to higher stock prices. Conversely, rising interest rates can lead to decreased investment and lower stock prices.

Consumer Price Index (CPI)

CPI directly impacts interest rates, bond yields, equity valuations, and volatility pricing. The number itself only tell half the story, market reaction depends far more on positioning, flows, and option dynamics.

• Positioning > Data

4 Major Questions to ask Before CPI and Economic Indicators

How is the Street Positioned?

Who owns what? How crowded is the trade? And in what direction?

• If everyone is leaning the same way, a small surprise can trigger a violent move

  • Directional Positioning: Are funds long or short bonds? Are equities heavily hedged?

  • Crowding: Is the trade consensus?

  • Dealer Positioning: Are dealers long or short gamma?

    - Gamma= measure of how the ROC of an option will change with fluctuations in the underlying price

• If the market becomes fragile, usually the street is heavily positioned one way. A small shock can force

  • Deleveraging: Sale of assets to quickly decrease debt

  • Dealer Hedging Flows: Buying/selling to offset risk

  • Stop-Outs: Forced liquidations when losses hit limits

  • Short Covering: Buying back borrowed shares from buyers

What is Implied Volatility (IV) Pricing?

• IV is the markets expectations of a future movement embedded in option prices

• IV tells you

  • How big a move is priced in

  • Whether options are cheap or expensive

  • Whether the market expects a shock

• High IV -> bigger market expectations

How do you value options using IV?

• Black-Scholes model finds price of an option "C"

S: Stock price

K: Strike price- predetermined price which a holder can call or put an option

r: Risk free rate

t: Time till expiry (t/365)

σ: Volatility

N: Normal Distribution= norm.s.dist(d,1) on excel

For example, a stock option could look like AAPL 260320 00275000

• This may be confusing at first... but

  • AAPL: Stock ticker for Apple

  • 260320: Expiry date, 2026/03/20

  • 00275000: Strike price, $275.000

1. Theoretical "C"

   - If formula>market, market is underestimating future movement

   - If formula<market, market is overcharging for risk

2. Delta [N(d1)]

   - Directional Exposure

   - Delta of 0.1= "lottery ticket", barely moves with stock price fluctuation

   - Delta of 0.5= "coin flip"

   - Delta of 0.9= "stock substitute", option nearly mirrors stock price fluctuation

3. N(d2) vs. Delta

   - Probability that an option expires "in the money (ITM)" and turns a profit

   - Higher N(d2)= deep in money

   - Gap between delta and N(d2) is variance risk

What is Skew?

• Skew is the mathematical proof of fear; when looking at an option chain, puts are almost always more expensive than calls

  • Big institutions own billions, they don't need "lottery tickets" they need "insurance"

  • High demand for puts drives IV higher

• If the skew is very steep before the CPI, the street is terrified of a bad number and are overpaying for its insurance

What are Stops?

• A stop is an order that says "If the price hits X, get me out immediately"

• Traders put all of their safety nets in the same spot, these are called liquidity clusters

  • Technical levels: Just before a recent low

  • Psychological levels: Round numbers like 100 or 250

  • Moving averages: Algorithms often sell if stock crosses a moving average

• For example, Apple drops from 265 to 260...

  - At 260, it hits a stop cluster

  - Thousands automatically sell

  - This creates a liquidity void= not enough buyers

  - Price automatically tanks to 255