The Bernanke put — a.ka. that almost magical and metaphysical QE2 effect — appears to be having an impact on equity options skew already.
Simply explained: skew is what happens when the price of calls does not equal the price of puts exactly. That is to say when out out-of-the-money calls cost more or less than the equivalent puts.
So essentially, skew happens when the market is willing to pay more for protection on one particular direction in the underlying than the other.
Now here’s the interesting thing. Before Ben Bernanke’s Jackson Hole speech the skew in the S&P 500 had reached very high levels, with downside protection trading very expensive.
But as a second round of quantitative easing became increasingly expected by the market, that skew began to ease significantly.
Zerohedge presents a good chart from UBS reflecting the trend this week:
As UBS comment:
As we mentioned in our report out earlier this week, These Go to 11, many investors have interpreted a more engaged Fed as providing put protection under the equity market, decreasing the potential for adverse outcomes.
This dynamic can be observed most directly by looking at the option market’s implied volatility skew, which measures the difference between the cost of puts and calls. As illustrated below, this declined significantly following the Fed’s hint at additional QE on September 21. Why buy downside protection when the Fed has done it for you?
A nice way to think about it comes way of Dean Curnutt, President of Macro Risk Advisors. As he explained to FT Alphaville on Friday:
The Fed is a seller of volatilty, and if someone else is giving you a put, you have much less need to buy them and they will inevitably begin to trade cheaper.
Which — post-Fed announcement — is exactly what happened. As the following chart courtesy of Curnutt shows, the skew between a 25 delta put and a 25 delta call on the S&P 500 index fell from 6.2 on November 2 to 4.8 come November 5:
Which is all well and good.
But there is another point that Curnutt makes, which is that the Fed may be unwittingly displacing all that volatility elsewhere:
…it looks like there’s a divergence between currency and equity volatility. The Fed may be compressing equity volatility but it’s incentivising currency volatility in its place.
He measures this divergence by looking at the correlation between the Vix index — which is derived from the implied volatility of the S&P 500 index — and the implied volatility of the UUP dollar index ETF:
Note to what degree the divergence widens following the FOMC’s September meeting, despite a previously strong positive correlation.
All of which makes Curnutt conclude (our emphasis):
All in all, we are left thinking that there may be a derivatives market analogue to the “law of conservation of energy”. Perhaps it reads: “volatility cannot be created or destroyed, it can only change form”.
When the financial sector went bust in 2008, it was saved through the massive backstops provided by governments. Two years later, the VIX is 50 points lower but the strain on fiscal balance sheets has introduced credit risk into the realm of governement bond markets. In addition, Central Banks are finding it necessary to pursue QE and the like to weaken currency and support growth. Do FX implied volatility levels fully reflect this volatility transformation?
Which has to make you ask: will the granting of the market’s wish for liquidity actually lead to a much more sinister implication elsewhere?
In which case, perhaps the lessons of the children’s classic Aladdin should be noted:
When Aladdin uses the lamp to get riches and marry the princess for the first time, he has not truly earned them. It is only once he has been through a struggle and proven his worth that he can be entitled to his new position.
The Fed is the biggest seller of volatility – FT Alphaville
Risk on, risk off, risk on, risk off, risk … ruptured – FT Alphaville
Trading the correlation bubble - FT Alphaville