A Smart Risk/Reward Trade for the Upcoming Election

by Options Sensei

Elections, a potentially large price movement catalyst

The options market continues to brace for the upcoming U.S. election. As the date rapidly approaches, the bold trade is to sell the pumped up premium by assuming that not everything will be burnt to the ground. The elections can be viewed as a market-wide earnings event, or an FDA drug trial announcement due to its specific date — a potentially large price movement catalyst.

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Politics has rarely impacted the market beyond a few days

Historically speaking, however, politics has rarely impacted the market beyond a few days.  We can view the two biggest surprises in the past five years — Britain’s decision to leave the European Union and Trump’s 2016 presidential victory – to see how the options market pumped up implied volatility only to drop once the events passed.

Implied volatility (yellow line) spiked higher

Using SPDR 500 (SPY) options as a proxy for the overall market, one can see that implied volatility (yellow line) spiked higher, leading up to those events, but quickly reverted lower towards realized volatility (blue line).

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daily one year volatility chart

“Election hump” developing several months ago

Now, if we look at VIX and its futures contracts, which represents the implied volatility of the SPY across different time frames, we can see an “election hump” was clearly developing several months ago. This VIX term structure image, in early July, shows how the November contract was getting pumped up, but also anticipated a fairly quick drop following the election.

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vix futures and historical prices

 

If we fast forward to today, we see the ‘hump’ has shifted to the here-and-now and there’s still an expectation of a decline following the election.  It’s also notable that on top of the premium November options to the cash VIX, 28 vs 25,  is the huge spread, both have above-realized volatility,  which stands at just 16.

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vix futures terms service

A record amount of hedging going on

Betting that implied volatility will revert back towards realized volatility could go down in history as the short trade of a lifetime. Yet betting that calm, not chaos, will take hold on Wall Street is proving easier said than done. As one of the most-expensive event risks on record, investors who place a wager on muted stock swings in the Nov. 3 vote aftermath could net riches — if history’s an indicator.

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Disputed election brings caution

But, the prospect of a disputed election is causing even the most seasoned professionals to approach with caution. According to Bloomberg, there’s a record amount of hedging going on, leading to the crazy skew I described above.

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bloomberg record hedging chart

if things really go off the rails we could see a spike in volatility back to 80 plus pandemic days

For the bold willing to sell or write these protective issues shorting calls in the VIX and its related products can bring windfall gains.  But it also comes with unlimited risk in that if things really go off the rails we could see a spike in volatility back to 80 plus pandemic days.

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Options360 service take more conservative approach to buy VIX puts

In the Options360 service, we are taking a more conservative approach to buy VIX puts.  Specifically, the 22 strike puts which expire on November 25th.  They cost just $0.30 per contract and my assumption is if there is a quick reversion and the VIX drops back below 20 following the election these puts could be worth over $2 or an over-500% gain.

Volatility landscape offers rich premiums for the brave

In buying puts I know my risk is limited to the cost. All in, the volatility landscape offers rich premiums for the brave but I’m taking the safer route which can still offer huge rewards.

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