Inflation – Consumer Price Index

One of the most important economic releases watched by traders all over the world, after central banks meetings is the time the inflation is released. Inflation is called Consumer Price Index, or the CPI. You can go on the economic calendar and look for the CPI to be released in all the important economies in the world: United States, Eurozone, United Kingdom, Australia, Japan, etc.

CPI – Monetary Policy Thermometer

The CPI is so important because central banks establish the monetary policy based on the inflation level and the standard interpretation goes like this: if the inflation is moving to the upside, it is said that there are inflationary pressures in the economy and the expectations for the central bank to come and increase the rates in order to fight inflation are becoming real. The outcome will be that the currency will move to the upside as if the expectations are that the central bank will hike rates than everyone wants to own a currency that pays a higher interest rate.

The opposite is true as well: if the outcome of the CPI is lower than expectation and well below the central bank target, then the market will try to position for a rate cut from the central bank next time they will meet and a rate cut is always being viewed as negative for a currency. In our case, when trading binary options, in the case the CPI is higher than the forecast value, it should be bullish for the currency, hence we should buy call options.

CPI Releases Move the Currency

If the CPI release falls short of expectations, then it is being viewed as negative for the currency and therefore we should buy put options. Central banks have a mandate and the classical mandate is to keep inflation below or close to two percent. This means that higher inflation levels than 2% are not desirable, as money is losing value, while lower inflation levels are a threat as below zero and we’re talking about deflation and not inflation anymore.

Inflation or the CPI is being released on a monthly basis and has some variations in the way it is calculated as it is different from country to country. Just to give you an idea, in the United States, the Federal Reserve of the United States is looking at the core inflation and not at the overall CPI. Core inflation means prices of oil and energy are not considered in the whole equation as they have the tendency to be volatile and cyclical, so at the actual release one should interpret the core number and not the full inflation headline.

What is Monetary Policy Going to Do Next?

In interpreting the inflation numbers, traders try to have an idea about what the central bankers are going to do next time they meet. In October 2013 for example the CPI print in Europe came at 0.6% on expectations of 1.1% and the Euro tumbled across the board. The reason for that was that two weeks later the ECB (European Central Bank) was meeting and expectations that it will cut the interest rates grew stronger and stronger. It turned out they did cut the rates and by the time they did that market plunged a couple of hundreds of pips more.

What I am trying to say here is that one can position in trading binary options on a CPI release, after the fact, but choosing a bigger expiration date. It is a well-known fact when the interest rate is discussed so setting the expiration date of your option beyond that that is the way to go. In the above example, after the CPI weak print, trading put options with end of month expiration date was the way to go and after two weeks the option would have expired in the money.

Trading the CPI

Trading the news is difficult nowadays as markets are influenced by algo trading or algorithms. Because of that, trying to pick the right direction on a news release is difficult, but not an impossible task. The way to go is to wait for the news to be released and then trade based on the actual figure when compared with the expectations. If the actual is bigger than the expected headline, let’s say on Australian CPI, then chances the central bank is going to come at the next meeting and increase the rates or at least use a hawkish/bullish tone are really high.

In this case, if one wants to trade binary options based on an Australian dollar financial product, say audusd, then trading call options would be wise. As for the expiration date, one has to go and check the economic calendar and see when the next interest rate decision is being scheduled. The call option should go end stretch with the expiration date beyond that date in order for it to have good chances for expiring in the money.