This is not investment advice. The information provided is for educational and informational purposes only and does not constitute a recommendation to buy or sell any financial product.
The Wholesale Price Index (WPI) measures the average change in prices at the producer level, before the prices reach the consumer. The index is published by national statistics agencies, and the index is a useful macro signal for traders who want to position ahead of inflation data. The WPI is closely related to the Producer Price Index (PPI) in the US, and the two are often used interchangeably. The WPI captures the prices of goods at the wholesale level, and the index is a leading indicator of consumer inflation.
How the WPI is constructed
The WPI is constructed from a basket of wholesale prices, weighted by the importance of each item in the wholesale economy. The basket includes raw materials, intermediate goods, and finished goods at the producer level. The weights are based on the value of the items sold at the wholesale level, and the weights are updated periodically to reflect changes in the economy.
The WPI is published monthly, and the release is a major event for traders who follow inflation data. The release includes the headline number, the core number (excluding food and energy), and the detail by category. The traders who follow the release look for surprises, and the surprises move markets.
The WPI is different from the Consumer Price Index (CPI), which measures the change in prices at the consumer level. The WPI is a leading indicator of the CPI, because changes in wholesale prices are usually passed through to consumer prices with a lag. The lag is usually a few months, and the trader who anticipates the pass-through can position ahead of the CPI release.
Strategies for using the WPI in stock trading
The first strategy is to trade the sectors that are most exposed to the WPI move. A rising WPI signals rising input costs, and the sectors with high input costs (manufacturing, materials, energy) are the most exposed. A trader who expects a rising WPI can short the high-input-cost sectors and long the low-input-cost sectors (services, technology). The trade is a relative-value trade, and the trade benefits from the dispersion in the sector returns.
The second strategy is to trade the central bank's response to the WPI. A rising WPI signals rising inflation, and the central bank may respond by raising interest rates. A trader who expects a hawkish response can position for a stronger currency and a flatter yield curve. The trade is a macro trade, and the trade benefits from the dispersion in the asset class returns.
The third strategy is to trade the surprise component of the WPI release. A trader who has a model that predicts the WPI number can position ahead of the release, and the trader can take a position that benefits from the surprise. The model is based on the historical relationship between the WPI and other macro variables (oil prices, commodity prices, currency moves). The model is not perfect, and the trader should expect a small percentage of losing trades.
The fourth strategy is to use the WPI as a filter for other trades. A trader who has a stock-specific view can use the WPI as a filter to decide whether the stock is in a favourable macro environment. A stock that is hurt by rising input costs is harder to trade in a rising WPI environment, and the trader may want to wait for a more favourable environment before taking the position.
The limitations of WPI-based strategies
The first limitation is that the WPI is a backward-looking indicator. The WPI measures the change in prices that have already happened, and the index does not predict the future. The trader who uses the WPI as a forward-looking indicator is making an assumption that the trend will continue, and the assumption can be wrong.
The second limitation is that the WPI is subject to revisions. The initial WPI release is often revised in the following months, and the revisions can be large. The trader who acts on the initial release is exposed to the revision, and the trade can move against the trader when the revision is published.
The third limitation is that the WPI is correlated with other macro variables. A trader who trades the WPI is implicitly trading the broader macro environment, and the trade is not a pure WPI bet. The trader who wants to isolate the WPI bet needs to control for the other variables, and the control is difficult to achieve in practice.
The fourth limitation is that the WPI is not always a leading indicator of consumer inflation. The pass-through from wholesale prices to consumer prices depends on the sector, the country, and the time period. The trader who assumes a stable pass-through is exposed to the risk that the pass-through changes, and the trade can move against the trader.
How to manage the risk
The honest answer is to use the WPI as one input among many, not as the sole basis for a trade. The trader who has a stock-specific view, a sector view, and a macro view (including the WPI) is using the WPI correctly. The trader who has only a WPI view is exposed to the limitations of the WPI, and the trade is fragile.
The second answer is to size the WPI trade to a small percentage of the account. The WPI is a macro variable, and the trader's edge on a macro variable is usually small. The trader who sizes the trade to 5% or 10% of the account is exposed to a small loss if the trade is wrong, and the loss is recoverable. The trader who sizes the trade to 50% or 100% of the account is exposed to a large loss, and the loss can be difficult to recover from.
Related resources
Where to start
If you are evaluating the WPI as a trading signal, the most useful exercise is to backtest a simple WPI-based strategy on historical data, and to evaluate the result. Our broker comparison lists the asset coverage and the research at each broker, which together tell you what is on the table before you start trading.