How the Options Market Responded to QE3
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On Thursday, option markets reacted to the Federal Reserve announcement in a few ways. First and most obviously, implied volatility fell hard as stocks and other risky assets rallied. While it will take some time to see whether the new Fed program is successful at shaping market expectations, my initial reaction is that this will put a real floor on U.S. equity prices.
Second, implied volatility skew dropped as investors became more willing to hold unhedged assets and to sell calls and buy puts at lower prices. This is another bullish sign. The 25 delta three-month SPDR S&P 500 (SPY) implied volatility skew was as low as 0%-10% in the years before the financial crisis; since then, it has moved in a range of 30-45% most of the time. A major shift in investor sentiment could see this skew estimate fall back toward pre-crisis levels.
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