By Chris Hausman, CMT, Swan Global Investments Director of Risk Management and Chief Technical Strategist
Ladies and Gentlemen – “The President of the United States” …and option implied volatility.
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With the Presidential elections just around the corner, now is good time to examine whether or not option implied volatility is affected by the uncertainty regarding the future leadership of the United States and what sort of option strategy might serve as an adequate hedge. No matter what the election polls say, there is always some element of inconclusiveness surrounding Presidential elections. Just like the stock markets, there seem to be “outliers” with respect to margin of victory, or lack thereof, when it comes to Presidential winners. Warren Harding defeated James Cox in 1920 with the largest margin of victory at 26.2%. On the other hand, John Quincy Adams was elected in 1824 with a negative margin of victory marked at -10.4% of the popular vote.
The nice thing about option implied volatility is that it doesn’t belong to a political party and it can’t vote.
As a review, implied volatility is calculated by current option prices in the marketplace. In other words, market prices for options are entered into an options pricing model and the implied volatility is then extracted. Implied volatility represents a consensus – a consensus as to what the future volatility of the underlying may be over the life of the option. It can be challenging to predict the future volatility of an underlying stock because there are many factors in the marketplace that simply cannot be quantified or easily identified. More specifically, implied volatility must include some element that accounts for the direction, speed, and magnitude of an underlying stock’s movement. In addition, options are subject to simple supply and demand which can greatly impact pricing.
The table below shows the S&P 500/CBOE volatility index (VIX closing prices) 1 month prior to the election as well as 1 month after the election. The question we should ask: is there a discernable change in option implied volatility because of the uncertainty regarding the outcome of a Presidential election, or are economic factors and market dynamics still the main driving force of implied volatility?
The VIX has not been in existence as long as we have been electing presidents, so the data is scant at best. Moreover, one could make the argument that 2000 (dot.com bubble and inconclusive election) and 2008 (financial crisis) were special situations. Nevertheless, one can see that both the average and median do show a slight increase in volatility up to the election date. Most importantly, option volatility remains elevated after the election. It would not be fair to solely look at the data without some analysis as to what was occurring in the economy. In 2000, the dot.com bubble was well under way and the Federal Reserve was raising interest rates during the first half of the year. Ultimately, the U.S economy would slide into recession in early 2001 and therefore, it is difficult to conclude that the election in 2000 was a decisive factor in increasing volatility. The financial crisis and housing market implosion in 2008 held the economy in check for the year until the U.S economy emerged from recession in 2009. Another related point, the months of September and October are known for heightened volatility regardless of whether or not it is an election year. Therefore, it is difficult to conclude that elections have a greater impact on volatility than usual. The health of the economy and seasonal influences will have a much greater effect on option implied volatility rather than the budding results of an election.
However, if one does want to take advantage of the potential for elevated volatility levels and a post-election sell-off, there are option strategies that can do so.
One sort of “election hedge” would employ the use of calendar put spreads. Most option spreads are created within the same expiration, but it is possible to construct spreads with multiple expiries. One possible strategy on the Standard and Poor’s 500 Index (SPX) would be to purchase the November 18, 2016 expiration 7.5% out of the money put and sell the October 21, 2016 5% out of the money put. The objective is trifold: construct a spread with long exposure to volatility, reduce the overall cost of the hedge, and provide protection leading up to and beyond the election. Using 2125.77 in the SPX as the closing price (9/14/2016), a trader could purchase the November 1965 put for $22.00 and sell the October 2020 put @ $17.00 for a total cost of $5 (assumes near mid-market execution and does not account for slippage and transaction costs).
SPX: Short OCT 2020 Put and Long NOV 1965 Put Profit and Loss Graph Prior to October Expiration
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As with any option strategy, it is important to fully be aware of the risks. The entire debit of $5.00 could be lost if the expected scenario does not materialize and the S&P 500 could move violently down before the short October 2020 puts expire causing the spread to lose value. The good news is that even though the spread is short the higher strike put, it is still considered a defined risk strategy. If both put options were to go very deep in the money, the maximum loss is limited to the difference in the strikes plus the debit paid. If the October option expires worthless, the strategy will simply be long the November 1965 put for the initial debit paid, $5.00.
SPX: Long NOV 1965 Put Profit and Loss Graph Post October Expiration
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Options can provide a tremendous amount of versatility when it comes to strategy construction. No matter how you construct an option position to meet your intended goals, always remember to define your risk ahead of time and adhere to a disciplined approach. Learning about options can be a daunting task, but as John Adams once said, “Let every sluice of knowledge be open and set a-flowing.”
This article was provided by our partners at ETFTrends.