Dec 20, 2021
Options Trading and Taming Inflation
The USA is experiencing inflation unlike any in the last thirty or forty years. High energy prices, broken supply chains, pent up demand due to Covid, and labor market disruptions are all part of the picture. Jerome Powell did not surprise when he announced faster tapering of the Feds bond purchases and the likelihood of at least two interest rate hikes next year. The truth of the matter is that the Fed needs to walk a tightrope in raising rates so that they don’t overshoot and drive the economy into another recession.
Video: Discover the OODA Loop (Observe, Orient, Decide, and Act)
The Results of Fed Actions to Tame Inflation
In an interesting article in The New York Times Paul Krugman (Nobel Prize-winning economist) discusses how raising interest rates in the early 1980s to kill stagflation resulted in nearly a decade or increased unemployment. Many folks remember that when the Fed Chairman at the time, Paul Volker, raised rates that it effectively stopped stagflation but only after driving the country into a recession. What many have forgotten, or never knew, was that unemployment went up to 11% and did not return to the previous 6% rate for nearly eight years.
This graph from the Fed tracks 1980s prices (which went down) and unemployment (which went up).
Anyone wondering why the Fed seems to tiptoe around when raising interest rates will better understand their timidity by looking at this graph of seven years of higher unemployment brought on the policies of an institution (the Fed) whose dual mandates are to control interest rates and maintain maximum employment!
Options Trading and Taming Inflation
Options trader can make money whichever way the economy and the market go. As we often note when this go badly, as Americans we feel terrible. But, as Gordon Gekko we are happy making profits. In order to profit in options trading we need to pay attention to what is going on in the world as those things affect the price fluctuations on stock charts which we trade to make money. Our DRINC acronym for Democrats, Russia, Iran, North Korea, and China covers much of what we need to pay attention to. The Fed, however, is in a category all by itself. As the old saying goes, you can’t fight the Fed. When the Fed turned on the spigot in the depths of the Covid crash we turned on a dime and, after making money on the way down, made money on the way back up.
Although the Fed’s dual mandate is maintaining maximum employment and keeping interest rates low they are fully aware of how their actions affect the markets. Powell even alluded to this in a recent announcement. Our interest in the Fed may seem obsessive to some but it is part and parcel (along with keeping track of DRINC) of spotting those things that will drive the market and, paid attention to, drive our profits in trading options.
Will Fed Actions Lower Inflation?
When too much money flows into the economy and interest rates are too low, inflation tends to happen. This time around, however, there are factors unrelated to too much stimulus and near-zero interest rates driving prices. As we noted at the outset, supply chains are a mess, the Covid-19 virus has another more-infectious variant, and people are leaving one job to go to another at historic rates. Freezing the economy with higher rates and less financial stimulus may force people remain in jobs whose wages have been frozen for decades but will do nothing to fix the supply of computer chips or shipping containers or, for that matter, the continual mutation of the coronavirus across the globe. A valid concern that options traders need to consider is that the Fed will raise rates next year, drive up unemployment, and not effect things like the prices of used cars because there will still not be enough computer chips to make enough new cars. As options traders we cannot fix any of this but we can pay attention and profit along the way.
