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With the US Presidential election coming up in just a few weeks, it is time to start planning how we can profit from the outcome. It's illegal to directly bet on the outcome of an election in the United States, but we can still make money from anticipating the reaction of the financial markets.

Let's first consider the likely impact of each outcome of the election. Right now, the latest Gallup poll has Romney ahead of Obama 50 to 47 percent among likely voters. Intrade (a gambling site in the UK), however, is currently giving Obama 58.4% odds verses Romney at 41.6%. I put more weight on Intrade here and believe that market participants are expecting Obama to be reelected, but Gallup does make that assumption more questionable. Also, I'm still of the opinion that Obama is likely to be reelected as incumbents tend to have the odds in their favor. Regardless, it is very important to try to pinpoint what other market participants believe the outcome of the election will be. If everyone expects a certain outcome, that outcome would be fully priced into the markets and all the risk would be in an alternative outcome taking place.

Since people probably believe Obama will win, more of the risk would be with a Romney win. This election is far from certain at this point so I do think there will still be a reaction in the financial markets if Obama wins, but I think the reaction would be larger in the slightly less likely event Romney wins.

Now that we've discussed the risk we can expect from either possible outcome (sorry 3rd parties, this isn't going to be your year), let's discuss what directional move we should anticipate. Bloomberg recently wrote a good article about the possibility of equity market weakness going into 2013 due to tax hikes. To make a long story short, the idea is that since the capital gains tax rate is set to increase next year, some investors will be more inclined to realize their gains this year in order to lock in the profits under a lower tax rate. Here are a couple interesting lines I'd like to share from this article:

... That means the stock price would need to rise at least 9 percent for an investor to be better off selling in 2013...

The last time there was a significant increase in the capital gains tax rate -- in 1986 -- positive realizations spiked 91 percent to $328 billion from $172 billion a year earlier, according to the Tax Policy Center. Most investors waited until December to sell, according to a 1994 report in the National Tax Journal.

The above quotes are pretty compelling and lead me to believe that if taxes are set to go up we can expect equity weakness going into the year end. Obama is the one set to let taxes go up, so I think the markets would view an Obama win to be negative, but since they already expect him to win the downside risk is probably only marginal. Likewise, Romney not only isn't expect to raise taxes, but he is expected to cut them. In the second presidential debate Romney actually said that under his plan he will cut the capital gains rate to 0% for individuals making under $200,000 per year. In the event Romney were to win the election, I'd expect the market reaction to be very positive. Since a Romney win is the less expected outcome, I'd anticipate a Romney win to result in a move up in equities more than twice as large as a Obama win move down in equities.

I think the financial sector is likely to see the greatest impact from the outcome of this election so I'd consider placing trades around XLF, FAS, and FAZ if you are limited to trading equities/ETFs. If you believe Obama will win I'd suggest going short XLF, or long FAZ if you'd prefer using a leveraged ETF. If you think Romney will win, I'd suggest going long XLF, or long FAS if you want to use a leveraged ETF.

As far as timing goes for this trade, I would advise waiting as long as possible so we can have a better idea of the outcome going into this risk event. Also, waiting longer to implement the trade takes out more of the exogenous risk from something else impacting the markets (Europe, Iran, who knows). If you are limited to trading equities/ETFs, I'd place my trade in the afternoon on November 6th.

If you can trade futures or Forex, we have a much better option here. Since these markets trade approximately 24hrs per day, you could wait until the votes start coming in to place your trade. I think it is very likely this election will be determined by Florida, Ohio, and Pennsylvania so it is likely we'll be able to be reasonably certain of the outcome of the election once polls close in those states. According to Ballotpedia.org, polls close at 7:00PM in Florida, 7:30PM in Ohio, and 8:00PM in Pennsylvania. (Florida falls under both Eastern and Central time, so some of the polls would close at 8:00PM EST, but the majority of Floridians live in Eastern time. It is likely we'll have a pretty good idea of which way Florida is going sometime shortly after 7:00PM once polls start reporting.)

What I plan on doing is looking at these 3 states and see how the votes start coming in. At the same time, I'm going to go back and reference the results county by county for the for previous elections. Be sure to find out in advance precisely what the swing counties are and pay special attention to how the results are coming in for each. (uselectionatlas.org is a good site to use to reference the results of previous elections.) By comparing the results as they come in real time verses the results from previous years, I think we have an excellent chance of calling this election accurately ahead of other market participants. Once I'm confident of the outcome, I plan on going long ES (e-mini S&P 500 futures contract) if it looks like a Romney win or short ES if it looks like Obama will win. If you're trading Forex, I'd go long the dollar in expectation of risk off if Obama wins or short the dollar for risk on if it looks like Romney will win.

Good luck and be sure to get out and vote!

Source: Trading The U.S. Presidential Election