Investors are turning to volatility trades to profit from the close US elections

Investors are trying to profit from uncertainty over the outcome of the US presidential election campaign by resorting to complex derivatives trades that they believe can benefit from moves in the stock market, regardless of who wins.

With less than 30 trading days to go, the election remains extremely close and risks a repeat of the disputed 2020 result.

More and more investors are trying to take advantage of this potential market turmoil by betting on volatility to spike in the coming weeks.

According to an analysis by UBS, the options markets are currently pricing in a price increase in the reference stock index S&P 500 of around 2.8 percent on November 6th, the day after the vote.

That number has been gradually increasing over the past month and many investors expect it to continue, said Maxwell Grinacoff, head of U.S. equity derivatives research at UBS.

“People are starting to pay attention and question whether this level of implicit movement is justified,” he added. “Most people I spoke to said it [this] is probably still too cheap,” meaning the size of the implied move is likely to increase.

At this point before the 2020 election, options focused on the day after the election were trading at similar prices before surging just before the vote.

The S&P 500 rose 2 percent the day after the 2020 election and 1.1 percent the day after the 2016 election.

In part, the pricing reflects a hedge to protect against potential losses elsewhere in investors’ portfolios after stock markets posted strong gains so far this year. However, some investors are also betting in the hope of profiting from increasing market jitters.

After much investor speculation about the size and timing of interest rate cuts by the Federal Reserve, which cut borrowing costs by half a percentage point last month, analysts now expect the November vote to be the focus of stock markets.

But the tight race means trading volatility is seen as a safer bet than guessing which stocks or sectors will benefit from a win by former President Donald Trump or Vice President Kamala Harris.

“Our base case still assumes this is fundamentally a fallacy, and most clients agree with the same view,” said Stuart Kaiser, head of U.S. equity trading strategy at Citi.

“If you’re talking to a client who thinks Trump is 60-40, you could talk about owning bank stocks. If you think Kamala is more likely to win, it makes sense to trade a basket,” he added. “But if you believe it is 50:50, it will be very difficult to trade directionally, it is more of a volatility trade.”

Trading volatility typically requires investors to use more complicated derivative trades, resulting in a number of complex strategies with names like “straddles” and “collars” that involve buying and selling multiple derivatives linked to individual stocks or an index such as the S&P 500 are bound.

Investors can also buy and sell derivatives tied to the Vix index, the market’s “fear indicator” that uses the price of S&P 500 options to create a proxy for expected market volatility over the next 30 days.

Analysts at Cboe Global Markets, the company that runs the Vix, noted on Monday that there had been “tremendous” demand over the past week for Vix call options, which pay out when the index rises.

Kaiser said another popular new trade among clients is selling Vix put options. Puts give the buyer the right to sell at a set price. However, they generate income for the seller as long as election-related jitters keep the volatility index above a pre-agreed level.

Cboe Global Markets last week listed a new type of volatility-linked product that is tied to actual rather than expected volatility. The launch is timed to reflect an expected increase in demand for hedging and volatility trading ahead of the election. It also plans to begin trading a new type of option related to Vix futures this month.

Some investors have been buying up Vix futures contracts that expire at the end of November. Because the Vix is ​​forward-looking, contracts expiring a few weeks before the election have always come with a premium.

However, the price of futures expiring a few weeks after the election is approaching the price of the October contract. In theory, the November future should reflect the expected volatility in December, but traders expect demand for even this contract to surge in the final phase of the election campaign after the earlier contract expires.

Volatility tends to increase before presidential elections and then falls back to normal levels shortly afterward. Ed Tom, derivatives strategist at Cboe, said markets expected this year’s vote to follow a similar pattern, despite some concerns about whether the result could be challenged. Although S&P 500 options price in large potential swings on the day immediately following the vote, the implied volatility for the following days is much lower.

“Options traders are still expecting an additional premium for this election compared to other elections,” he said. “So that’s another way of saying that options traders believe there is more uncertainty associated with this election than many others in the past.” .[but]They don’t really anticipate a long-term contentious scenario, but treat it as if it were a regular election.”