GDP Growth, Inflation, and the Yield Curve

Current information about the most important variables effecting the stock market. The article discusses GDP Growth, Inflation and the Yield Curve environment and how these variables are effecting the TSX stock market, the Canadian US dollar exchange rate, and bond yields.

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GDP Growth, Inflation, and the Yield Curve

GDP Growth: Statistics Canada reported a rise of 2.8% in GDP annualized over 2006. The latest report available indicates an increase in GDP of 0.3% in May, 2007 after remaining nearly unchanged through April. Strong increases in retail and wholesale trade were present while a drop in oil and gas exploration constrained overall growth. GDP Growth is expected to remain strong through 2007 at an estimated 2.6% and subsequent 2.7 % in 2008.

Higher interest rates combined with an ease in housing starts and slowing profit growth will slow economic growth; however, a number of external factors, mainly a resurgence of the US economy, will keep the overall growth in the Canadian economy near 2.6% in 2007.

As a result of the anticipated growth remaining strong but constrained, the Bank of Canada is likely to hold off on interest rate hikes in the near term. As interest rates remain stable so too will consumption of capital investments as no higher rates will force consumers out of the market and no lower rates will attract new consumers. This policy will continue unless inflation increases, which would result in an increase in interest rates from the Bank of Canada to decrease consumption, or inflation decreases, which would result in a decrease in interest rates to revitalize consumption. Further, as a result of the continued moderate growth in GDP the yield curve has remained stable with a positive long term trend, the stock market although experiencing volatility has held gains through the year and the Canadian dollar has strengthened substantial against the green back and other major currencies throughout the year..

Inflation: Statistics Canada reported in July, 2007 a rise of 2.2% year over year in total CPI, which was identical to increases over the past 3 months. The Cost associated with owned accommodation was attributed for the fourth straight month to represent the most significant portion of the CPI rise. These price increases were offset by falling prices for gasoline, computer equipment and supplies, and natural gas.

Rising inflation due to a world wide economic expansion has caused many Nations to raise rates over the past few quarters in an attempt to ease inflation concerns. With the latest data placing inflation within the Bank of Canada’s target rate of between 1% and 3%, the case for a pause in interest rate policy remains strong. However, caution should be taken as a result of the latest interest rate movement in the US, a half percentage point decrease.

A pause in interest rates generally will not fane or dampen GDP growth and yield curves will remain stable. However, the market will normally predict a rate cut or increase before it is implemented by the Bank.

If the Bank of Canada decides GDP growth will decelerate too much without action, they will decrease interest rates at their September press release and many effects will ensue: the yield curve would steepen in a positive direction, increased consumer spending, yields on fixed income investments become less attractive than stock market gains, debt service costs decline, new equity becomes easier to place, equities rise on justified higher price/earning multiples, the expansion of the economy increases pace, unemployment falls, while inflation would likely increase pace.

Yield Curve: Long term yields on Government of Canada benchmark bonds have decreased recently as a result of market concerns of a pending rate cut in the future. As of August 22, 2007 the current yield was 4.49%. Yields on 3 month Treasury bills have also recently decreased but at a faster rate to 4.01% as of 21 August, 2007. This amounts to spread of 0.48% and implies a normal sloped yield curve that has recently steepened. This positive slope reflects investors expectations for GDP and inflation to grown in the future.

The TSX has experienced substantial gains over the past year while volatility has also been substantial. Under the current yield curve conditions the stock market still remains more attractive to investors than fixed income instruments and the outlook for the Canadian dollar is for further strengthening against the US dollar over the coming years.

Top 10 Option Investment Strategies

Top 10 Option Investment Strategies:

Neutral to Bullish Strategies

1) Long Call: Simply buy a call option on a stock. This provides unlimited upside potential and caps the associated risk at the amount paid for the stock option. For Example, say you have $1600 and think Google (GOOG) will increase in value: say it is currently trading at $500 a share but you only have enough money to buy 3 shares. Instead of buying the shares you decide to buy call options on Google (GOOG). Let’s say you want to be conservative and only buy options trading write at the money (strike of $500). Now you just need to choose the expiration month (do you think the stock will increase in value soon or will it take a while?) Say you believe Google (GOOG) will increase in value within 1 month. You buy September 500 Calls for $16 (you have $1000 so you can afford 1 contract (sold in 100 board lots). As long as Google (GOOG) Trades at $516 at expiration in September you have made a profit.

Say GOOG is trading at $550 at expiration of the call options:

If you had bough 3 shares your profit would be ($550-500)*3 = $150.

If you bought the Call Options your profit would be {(550-500)-16}*100 = $3400.

2) Put Writing (Short Put): Simply sell put options on a stock. This provides you with the option premium while your maximum risk is strike price of the option minus the premium received. Your max risk scenario would only occur if the price of the stock went to $0. For this strategy an investor will normally have a neutral to bullish market forecast. Say you are interested in Apple (AAPL) and think it will appreciate in value or remain the same. You can sell Puts on Apple (AAPL) and received the option premium in exchange for the risk that the stock may decrease in value up to the expiration of the stock options you sell. Say Apple (AAPL) is trading at $120. To be conservative you write put options with a strike price at the money ($120) for $6 each and an expiry in 1 month. Say you only write 1 contract, you will receive $600. While you are waiting for the option to expire you can invest that $600 elsewhere say in Google. At expiry, as long as the Apple (AAPL) is trading above (120 – 6 = $114) you have made a profit.

3) Married Put: This strategy is implemented by buying the stock and buying a put on the stock. This provides you with protection against a price decline while you can still participate in all upside in the stock price. The risk/reward profile is very similar to the Long Call; that’s why this strategy is also referred to as a ‘synthetic call.’ Lets go with Starbucks (SBUX). You buy 100 shares at $25 a piece for $2500 and want to protect yourself against a decline in Starbuck’s (SBUX) stock price so you buy puts right at the money because you are being very conservative. Say you only want to protect your stock from a decline for 1 month. You buy puts with a strike of $25 1 month to expiration for say $1. Now, the most money you can loose over the month is the $1 you paid for the put while you still can participate in any upside so as long as the Starbucks (SBUX) is trading above $26 at expiration you have made a profit.

Neutral to Bearish Strategies

4) Long Put: Simply buy Put Options on a stock. This strategy is implemented when an investor has a bearish forecast for a stock. Say you think Google (GOOG) will decrease in price over the next month. Instead of shorting Google (GOOG) you decide to buy put options on Google (GOOG) because you don’t want to put so much money at risk. Say Google (GOOG) is trading at $500. If you were to short the stock you need to be able to cover you position. Say you have $1500, you would be able to cover shorting 3 shares. If you buy puts and are conservative you could write at the money $500 puts for one month out for say $15. You could afford 1 contract (100 shares). If you had just shorted the stock you would profit as long as the stock declines in value, but you have unlimited up side risk. With the put options on google (GOOG) your risk is limited to you initial investment while your rewards could be substantial.

Say Google (GOOG) in one month is now trading at $450:

If you shorted the stock your profit would be ($500 - $450) * 3 = $150

If you purchased the puts your profit would be ($500 + $15 - $450) * 100 = $6500

5) Call Writing: Simply Write (Sell) call options on a stock. This provides you with the option premium while your maximum risk is infinite (the stock can potential increase to infinity, ha). For this strategy an investor will normally have a neutral to bearish market forecast. Say you are interested in Apple (AAPL) and think that it will depreciate in value over the next month or remain the same. You can sell Call options on Apple (AAPL) and receive the option premium in exchange for the risk that the stock may increase in value over the month. Say Apple (AAPL) is trading at $120 and you are going to be conservative and write put options with a strike price at the money ($120). You receive $5 in premium. As long as the price of Apple (AAPL) is less than (120 + 5 = $125) at expiration, you have made a profit.

6) Protected Short Sale: This strategy is implemented by shorting the stock and buying a call option on the stock. This provides you with protection against an increase in the price of the stock while you can still participate in the decline in the stocks price. The risk/reward profile is very similar to the Long Put; that’s why it is also know as a ‘synthetic Put.’ Let’s go with Starbucks (SBUX) again. You can short 100 shares at $25 a piece for $2500 and want to protect yourself against a rise in the stocks price so you buy calls on Starbucks (SBUX) right at the money because you are conservative. Say you only want to protect your stock from a decline for 1 month. You buy calls on Starbucks (SBUX) with a strike of $25 and 1 month to expiration for $1. Now, the most you can loose over the month is the $1 you paid for the put while can still participate in any decrease in the stock price. As long as Starbucks (SBUX) is trading for less than $24 at expiration you have made a profit.

Neutral Option Strategies:

7) Short Straddle: This strategy is implemented by simultaneously writing a put and a call option on the same stock with the same strike price and the same expiration date. This way, as long as the stock price remains somewhat stable you will profit. For example, say Google (GOOG) is trading at $500 and you think it will remain near that price over the next month: sell google (GOOG) $500 Calls for $16 and sell google (GOOG) $500 Puts for $15, both with expirations of about 1 month. As long as the price of Google (GOOG) at expiration in one month is trading above ($500 – (15 + 16) = $469) and below ($500 + (15 + 16) = $531) you have made a profit.

8) Short Combination (Short Strangle): This strategy is similar to the Short Straddle as you write a call and a put option; however, the difference is that with a short combination you use different strike prices. This way you can increase your window of profit opportunity just incase there is a price move. For example, say Apple (AAPL) is trading at $120/share and you think the price will remain somewhat stable over the next month but are a bit more causes than the Short Straddle Investor: sell Apple (AAPL) $130 Calls for $2 and sell Apple 110 (AAPL) Puts for $3; both with one month to expiration. As long as the Apple Shares remain above (110 – 3 – 2 = $105) and below (130 + 3 + 2 = $135) you have made a profit. This way you will receive less option premium but are more likely to make a profit.

9) Long Straddle: This strategy is the opposite of the Short Straddle; an investor will simultaneously buy a call option and a put option on the same stock with the same strike price and same expiration date. Investors use this strategy when they think a large price more will occur in a stock but are unsure of which direction the stock will move. This strategy can work well when a major anticipated decision is about to be made for the stock: buy-back program, law suite, new technology, earnings reports, presidential election. For example, say the United States Presidential Election will occur in the next month and you want to find a way to profit. Some stocks will move depending on which candidate wins and you decide to focus on Starbucks (SBUX). Say one candidate wants to increase taxes on milk and the other wants to decrease them. You know this will effect Starbucks (SBUX) bottom line so you decide to implement a long straddle because you are not sure which candidate will win. You buy calls and puts with the same strike price on Starbucks (SBUX) and same expiration month. When the decision is announce the stock will most likely move dramatically in one direction. As long as the stock moves in one direction more than the amount that you paid in option premium you will profit.

10) Time Spreads (Calendar Spreads): This strategy is implemented by buying and writing an equal number puts or calls on the same stock with different expiration dates but the same strike prices. Normally time spreads have a neutral basis but they can also be designed for a bullish or bearish basis. For example, sell $500 Calls on Google (GOOG) with 1 month to expiration and buy $500 Calls on Google (GOOG) with 6 months to expiration. You can make a profit if the Calls with a shorter time to expiration erode in value faster than the longer term calls. This tends to work as the time value component of an options value usually erodes faster the shorter the term to expiration. However, you need to consider other aspects of the options price like volatility.