What Does The Fed Have To Do With Options Trading?
If you’re a regular reader of this site, you may be wondering why I often write about the Fed. After all, this is an options research site, not an economics policy blog. However, understanding the Fed is in fact, a very important tool for options trader to have.
Here’s the thing…
What the Fed does and says impacts the two factors options traders care about most: market direction and volatility.
These days, when Bernanke and the Fed meet or speak, it becomes the main catalyst for big market moves. Moreover, Fed policy is one of the key drivers of market volatility (or lack thereof).
As such, options traders should pay very close attention to central bank policy. It’s almost impossible to make an options trade in this environment which isn’t influenced in some manner by what the Fed is doing or saying.
Okay, let’s shift gears a bit…
We often hear how the Fed’s bond buying is important to stock investors. Without a doubt, quantitative easing has been extremely beneficial to stock prices. But why?
What does buying mortgage backed securities (and Treasury bonds) have to do with high stock prices?
To answer that, let’s look at how the Fed’s monetary program is supposed to work.
First, the Fed buys large amounts of bonds like I mentioned before. Next, the sellers of those bonds, typically large banks and financial institutions, take the Fed’s money and invest it in assets like stocks, higher yielding bonds, commodities, and real estate.
All the money flowing into those assets should make everyone who owns them (which is just about all of us in one way or another) feel wealthier. More wealth leads to more spending. More spending leads to more production.
And more production should lead to more jobs.
Here’s the problem…
The Fed’s bond buying has definitely led to higher asset prices. Unfortunately, the impact on spending has been less than expected. Institutions (and consumers to some extent) have been using the additional proceeds as excess reserves – in other words, more savings.
It seems many people and businesses feel they need to have plenty of reserves in case of another financial meltdown. As such, the Fed’s stimulus has only been partially successful.
That being said, quantitative easing has been important in other ways, namely, investor confidence. While spending hasn’t increased as much as the Fed envisioned, asset prices have. And, when the Fed even mentions tapering stimulus, the market reacts harshly.
Despite what you may hear, at this point in time higher asset prices are better for everyone. Keep in mind, every little bit helps.
Look, you may not care one bit about the Fed, monetary policy, or economics in general. But, as an options trader, it pays to follow the Fed and understand what the central bank is doing.
Yours in Profit,
Gordon Lewis
Category: Options Trading
