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Option Basics: Impact of FOMC on the Markets

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I had a recent discussion with another trader who expressed his surprise over the market reaction (the S&P500) to the announcement of tapering on December 18th. We both expected the market would react negatively; instead it reacted with a strong positive move.

However, I know that market reaction to news is typically unpredictable; both in terms of magnitude (how large a price move) and the direction of that magnitude.

When it comes to the FOMC Minutes announcing policy changes, and the impact of those changes, the expectation is magnitude will be large, and duration will be longer than typical economic news; even the Jobs Report and Unemployment Rate (which generally last hours; not days).

To determine if our expectation is correct, we conducted a test of the impact of important FOMC policy announcements and changes. The test starts with the rate cut announcement on October 29, 2008, and ends with the announcement of tapering on December 18, 2013; a total of fifteen events. To determine the magnitude of the FOMC event, we compared the Close prior to the event with the Close on the day of the event. And, to determine the duration of the impact, we looked at how many days the market moved in one direction before reversing, and whether the initial direction of the movement was the same as the day of the FOMC event.

What were the results? First, the average absolute move (i.e., ignoring direction) was 1.5%. This indicates that an important FOMC announcement and implementation of policy has a large magnitude (including a large 5.1% move from a rate cut on 12/16/08). Other large moves (greater than average) occurred on: 1/2/09 QE1 Starts; 3/18/09 QE1 Extension; 8/27/10 QE2 Planned; 10/3/11 Operation Twist Starts; 9/13/12 QE3 Announced; and 12/18/13 Tapering Announced.

And second, average duration after the event is 2.3 days before reversing for 2.9 days. And, duration differs in direction from the event only 31.3%; thereby, 68.7% of the time the duration is in the same direction as the magnitude of the event.

In conclusion, while some may disagree with Fed actions (rate cut, operation twist, and QE), there is no question that Fed policy has helped the market move to new heights. It took only five-months for the market to bottom on 3/9/09 from the initial rate cut on 10/29/08. This is a clear indication that Fed policy has long-term implications; both for the market and the economy.

If you would like to learn more about options, and how to generate consistent weekly income trading options, go to Options Annex.

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