A Trader's View on Options Volatility & Elections

As Election Day nears, financial markets brace for potential uncertainty. By learning from past elections and their market impact, however, participants can evaluate trading strategies to help manage and perhaps even benefit from turbulence sparked by shifting political winds. 

Anyone trading the markets around election time must prepare for shifts in legislation, economic strategy, and regulation, all of which could affect volatility, sector performance, and sentiment after November 5. The 2024 presidential race, with its starkly different policy agendas, presents unique challenges for investors and traders alike. Markets generally prefer stability, but this election cycle is marked by unpredictability, including the possibility of a divided government. 

Vice President Kamala Harris holds a slight advantage of about three percentage points as of September 30, according to polls compiled by FiveThirtyEight, still well within traditional polling standard error, suggesting the race is still far from over. Some polling also projects Republicans to control the Senate, while Democrats lead the House race, but once again, these numbers could change as election time approaches. 

Historically, markets favor gridlock, which can reduce chances of sweeping legislative changes. However, if the election trends toward one-party control, this could inject additional uncertainty, pushing investors to reconsider the potential effects policy shifts may have on various sectors. In this scenario, increased hedging activity could lead to heightened volatility and elevated options pricing.

Understanding historical market volatility surrounding elections can provide valuable trading insight. The market's behavior during the last two presidential elections revealed a notable rise in volatility, particularly in the six months leading up to Election Day. This increase was likely driven by option traders adding hedges to their portfolios, particularly through S&P 500^® index (SPX) put options, which heavily influence the Cboe Volatility Index^® (VIX). 

As traders seek portfolio protection ahead of potential market-moving events, demand for puts tends to fuel volatility. However, following the week of the election, even after a temporary spike in the VIX, volatility seemed to subside as markets digested the results. In 2016, for example, the VIX dropped approximately 50%, from 23 to 11, within six months of the election. Similarly, in 2020, the VIX fell from 40 to 20 during the same period. Traders who paid premiums for protection via SPX puts during these elections found that prices for those options declined rapidly once uncertainty abated. This type of "volatility crush" is not unlike what can often be observed on the implied volatility of options on a stock before/after a quarterly earnings report. The key takeaway? Some traders consider "buying volatility" in advance of major events but trimming or removing hedges just prior to Election Day to avoid the chance of unnecessary costs.

Given the heightened potential for volatility during election cycles, traders may want to evaluate and consider the following actively managed strategies to help mitigate risk and potentially capitalize on market movements: 

• Monitoring the VIX: The VIX and other volatility indicators can provide valuable insights about market sentiment. Elevated VIX levels often suggest traders are pricing in heightened uncertainty and/or the potential for larger movements in the SPX, which could be seen by some as potential buying opportunities for those seeking to enter the market during periods of fear-driven selling. 
• Hedging with options: Traders can use options, such as buying protective puts or put spreads, to hedge against downside risk. Option traders can be particularly interested in hedging during periods of uncertainty when the cost of temporary protection is offset by the potential for sharp market moves. 

 Checking the current landscape, volatility has been on the rise over the past six months and could experience further upward pressure as Election Day draws closer. Some traders may claim this may present a potential opportunity for active traders to capitalize on with long volatility strategies, such as buying SPX options spreads or options on the VIX itself. For those looking to replicate SPX strategies with a reduced position size, there are the Mini SPX (XSP) options that are basically 1/10 the price. A long volatility put spread strategy in the XSP options could be considered either a bearish directional bias or a portfolio hedge. 

With the S&P 500 and its derivative product XSP having near all-time highs, it may seem counterintuitive to look for a bearish directional bias or hedging strategy. Still, in this instance, if a trader is concerned that a pullback in the overall market may occur and volatility could be on the rise, then a long volatility bearish put spread might make sense. 

For example, one could employ a 570/540 put vertical in the November 5 options that will expire on Election Day. For a cost of $4.60 per spread (equivalent to $460), the put spread would essentially cover downside risk from $570 down to $540 in the XSP (or $5,700 down to $5,400 in the S&P 500) for those looking to hedge, while simultaneously providing opportunities for bearish traders looking to capture a quick downside move. The $460 debit paid ($4.60 x 100 multiplier, excluding commissions) would be the maximum loss should the spread expire worthless. The break-even point for this spread occurs at $565.40, which is the 570 strike minus the $4.60 debit paid. The order is highlighted below. Of course, be sure to consider transaction costs. 

Why choose those strikes for our example? The 570 strike is essentially the at-the-money strike and was the most sensitive to changes in volatility given its relatively higher level of vega, the options greek that measures sensitivity to implied volatility. The 540 strike represents the recent low point the XSP hit back in the beginning of September. 

Should a pullback occur to that strike price, the spread could potentially move to a maximum value of $30 (the width between the strikes), less the $4.60 paid to establish the spread, at expiration. This would equate to a maximum gain of $2,540. Holding this position until expiration could prove costly, though, if volatility subsides and the spread declines in value. Just remember, as history has shown, these options can lose value very quickly once the event risk has passed (i.e., the "unknown" is now "known" which removes uncertainty), so traders will typically take the view that active management of these positions is paramount. 

While elections often introduce short-term market volatility, history shows this turbulence typically has subsided once results are known and the policy direction becomes evident. While there is no way to know if this will happen after this election, it can be important information to consider. Traders who monitor volatility indicators, hedge with options, and actively manage positions may be able to manage risk and potentially capitalize on market movements if volatility does indeed climb and if they can trade in and out of positions with precision. Just be mindful that these strategies are often capital intensive, involve multiple commissions, and require active management.