How the Pricing of Options is Affected by the Macroeconomic and Political Environment

Wow, that’s a mouthful. Obviously this article is a bit deeper than most of the posts on the site. If fact, if you’re a beginning option trader, you may want to skip it. I personally thought it was a great idea to step back and take a look at the big picture while you’re researching and decided what option strategy to apply to a certain trade.

Volatility equals opportunity, but the opportunities are always changing. One way that a lot of traders find an edge is by using fundamental or technical analysis to develop long and short theses on individual stocks – taking a bottom-up approach – and then using options to modify the thesis or manage position risk. Another way to generate trade ideas is by starting from the top of the economic chain – the global economy as a whole – and moving down to the level of countries, scenarios, and specific asset classes.

Since 2008, I have been paying more attention to the second sort of approach, looking at how the macroeconomic and political environment shapes the pricing of options on major asset classes. Here are a few examples of trade opportunities that have occurred in the context of a macro view.

The recession and the globally coordinated central bank response to it created a major opportunity for equity option traders. In 2009, mid-2010, and late 2011 to early 2012, selling equity implied volatility was, for the most part, an easy and a winning trade. The risk premium in SPX and CBOE Volatility Index (VIX) options was high, and that meant that investors who were net short options or who sold VIX futures were positioned to profit as those premiums declined.

Another trade that has been working well in recent months is to be a net seller of options on crude oil: the perceived risk of a blockade of the Persian Gulf or of military aggression against Iran has kept options on crude oil futures and the United States Oil Fund (USO) trading at a premium to the actual, historical volatility of the underlying. We have an iron condor in place in our Options Profits portfolio right now that has profited from the elevated volatility risk premium in USO. Barring some change in the political situation, I expect crude options to drift closer to the historical volatility of the futures in the coming weeks.

Expanding your scope beyond just stocks provides more trade setups and better opportunities for diversification. As I mention in the attached video, the concern about a “hard landing” in China and the recent sharp trend in the yen have pushed short-term option implied volatility higher compared with the historical volatility in the yen and the Australian dollar. We’re looking at a trade in the yen in my Hot Topic article for today.

To combine options trading with a macroeconomic outlook, you don’t have to be an economist. I think the key is to be aware and informed about major trends and events in the world economy and to allow that knowledge to inform your trading. Sometimes, very opinionated investors have a hard time disentangling their own politics – that is, their personal view of how the world should be – from an empirically informed outlook on how the world is likely to be. For example, commentators who have been warning about dramatic hyperinflation for years (or even decades) let their political ideology get in the way of sober analysis, leading them to be short Treasuries at some of the most inopportune moments in recent history. Perhaps one of the biggest challenges of letting macroeconomic ideas inform your trading is making sure that your investment theses don’t get ahead of the data.

Ultimately, though, I think that a macro-oriented approach to trading will become more and more important as economies and financial markets become more integrated. If you can combine economic and political awareness with the skilled analysis of volatility, you will be able to take advantage of whatever opportunities the world throws your way.

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Option Trading Secrets