4 Factors We Must Consider About The Presidential Election's Effects On The Market

| About: SPDR S&P (SPY)

Summary

Many analysts, such as those at Bloomberg, do not recommend hedging because of the costs of hedges at the present moment.

Still, we should consider cheaper hedges as we move into an unpredictable incumbent-less election.

What if we could develop a strategy that profits from and hedges against the strange risk profile of this election? I'll show you how.

While analysts continue to argue how the election of Clinton or Trump will affect the stock market, statisticians step back to look at the bigger picture. The historical data allows for a variety of analyses and can show clear patterns on election years. One that is often ignored - especially this year, as pundits aim to overemphasize the idiosyncrasies of the two candidates - is that elections without incumbents have almost invariably led to losses in the stock market.

Logically, this makes sense, as an incumbent-less election brings uncertainty no matter who wins. So, while CNN claims that Clinton will bring 2% gains to the market and Trump will bring 8% losses, this type of statement is not backed by actual data (surprised?). What is an investor to do in light of uncertainty and a statistical downside?

Many analysts, such as those at Bloomberg, do not recommend hedging because of the costs of hedges at the present moment. The data show that the costs of hedging the downside are significantly more than making a speculative bet on the upside. But I believe we are all forgetting something:

The upside is likely small, while the downside is quite high. It's easier to fall from our current all-time highs than it is to continue eking out 1% gains. The risk/reward as we head into the election is heavily weighted to the downside.

Still, we should consider cheaper hedges. The standard hedge that most investors think of is the long put. The problem is that puts are currently overpriced for what they offer.

How do you know if an option is overpriced? Compare the statistical volatility to the implied volatility. When the latter volatility is higher than the former, puts are extremely expensive for what they offer:

Below is this chart for the options volatility of the SPDR S&P500 ETF (NYSEARCA:SPY):

Thus, it seems like we are at an improper time to hedge with long puts. This is fine, because hedging with long puts is not a good idea in most cases. A better idea is one that takes into account all of the following aspects of the market as we move into the election:

  1. The upside is likely low
  2. The downside is likely high
  3. A continuation toward the upside will be accompanied with decreasing volatility
  4. A break toward the downside will be accompanied by increasing volatility

What if we could develop a strategy that profits from all of these facts? We can, but it requires a more complex options strategy. Let's look at it first, and then analyze it:

  1. Long DOTM put
  2. Short ITM put
  3. Long ATM put

We choose the strikes so that the above is opened at a net credit. We generally want to reduce the cost of the OTM put as much as reasonable so that we have a price similar to a bull credit spread. Because we open this at a net credit, we must calculate the max risk, which is simply ITM strike - ATM strike - credit gained at open, all multiplied by 100.

You can look at this strategy in a number of ways, as a number of combinations. I think the easiest way to understand it is through the two scenarios presented above: a slow upward gain in the market versus a correction/crash. Let's look at the first situation:

Scenario 1: The Limited Upside

If the market continues to climb upward, slowly, we have something similar to a bullish credit spread. The stock will rise to or above the strike price of the ITM put, reducing the value of that put option. We can then buy it back at a profit, closing the other puts if needed.

For this, we want a DOTM put instead on OTM put, as this reduces the break-even point. Overall, the position is a short theta, short delta play, short vega play. This allows us to benefit from time decay, increasing market prices, and decreasing volatility.

Scenario 2: The Unlimited Downside

We have what is almost an unlimited downside gain with the above strategy. So also we see it being bullish in the case of a slow upward movement, it is also a strong bearish speculative position. Should the SPY fall drastically, the strategy will reach a point to where you are net short on the SPY (if you think of it in terms of stock).

The reason for this is that we are long gamma. The closer the SPY is to the strike price of the ATM or DOTM put, the faster those puts increase in value. And not only do we have two long puts versus one short put but their values both increase more quickly than the ITM put; the ITM gains delta (implicit) value, while the other puts gain value in both delta and vega (volatility).

At a certain point, it is as if the ITM put does not exist and we are simply short 100 shares of the SPY. Now, you have the standard hedge most traders know of - a long put.

However, unlike other investors, you didn't spend any money to obtain that "insurance."

Notes:

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Note2: All unlabeled figures were created by me from data pulled from Yahoo and ADVN through R. Charts with blue backgrounds are from Etrade Pro.

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