Jim Iuorio, for CME Group
AT A GLANCE:
- Election year equities market returns are lower, on average, than other years and traders must consider policy risks
- Equity options trading is rising, and several strategies can assist traders in managing event risk
2024 has the potential to be a volatile year in financial assets due to the coming U.S. election. Much of the expected volatility makes perfect sense in that the outcome of the election will have implications regarding tax policy, government spending, tariffs and immigration – all of which could affect financial markets.
Since 1928 the average stock market return in a presidential election year is 7.5%, slightly lower than the overall average of 8.5%. The theory was that elections represented uncertainty, and equities don’t love uncertainty. In recent years something seems to have changed. In the last seven presidential election years (beginning in 1996) the average stock market return is only 2.8%.
However, that statistic could be misleading because it reflects the massive 40% move lower in response to the housing market collapse in 2008. If you remove 2008, the average jumps to a very healthy 9.71%.
One, unsubstantiated but interesting theory, is that the party in power may actively use monetary or fiscal policy to support an economy before an important election. Regardless of your opinions on what may be pushing volatility, it’s difficult to deny that these elections have become emotional affairs and that the emotion could easily influence shifts in market sentiment.
Options Growth Continues
For such major, potentially market-moving events, traders have increasingly looked to options to manage their exposure to risk in equity markets. The growth of options as a tool for risk mitigation and speculation has exploded in recent years. Options volume for CME Group equity indexes has risen from approximately 30 million contracts in the first quarter of 2015 to almost 100 million in the fourth quarter of 2023.
Options have been actively traded in the U.S. for over 50 years but, for most of the early years, were used almost exclusively by institutional traders. In recent years, information technology has opened the door for greater retail education and, consequently, explosive retail growth. Similar volume explosions have occurred in brokerage houses that specifically cater to the retail trader. Of all financial instruments, options may be the most misunderstood.
Defining Risk Around Events
Yes, they can be used for highly leveraged and speculative trades, but it’s also true that they can be structured to clearly define maximum risk and to protect trading capital. With options, a trader can also express a trade idea based on the expected volatility of an asset that may be directionally agnostic. In other words, if a trader believed an asset may have an explosive move in either direction, as a result of a binary headline event, they could buy a straddle, which is buying the same strike price put and call, with an expiration date after the headline event.
We often see these types of trades placed before a major macroeconomic release or a company earnings report. If the underlying asset moves further from the strike price than the cost of the option, the trade would be profitable.
Short-Dated Options Trades
There are several ways to structure options trades to fit your thesis for direction and potential price swings around a scheduled event like an election. Of course, the prices for similar structures will vary as November approaches.
Here are some examples:
1. Call Spread
- In early April, the Friday E-mini S&P 5320-5340 call spread could be bought for approximately 7.5 tics or $375 (7.5 X $50). The underlying June futures was trading at 5280 or 40 tics below the lower bound of the call spread.
- This trade has 18 days until expiration and it encompassed both the April employment report and CPI report. If the data comes out friendly to the stock market and we have a rally, the rally must take the market to a minimum of 5327.5 at expiration to break even on the trade.
- That’s the amount you paid plus the lower strike price. If the market is above the upper bound of the spread, 5340, at expiration you would make a profit of 12.5 tics or $625. We arrived at that number because the spread is 20 tics wide but we paid 7.5 tics. So 20 minus 7.5 equals 12.5 tics. Each tic is worth $50, so $625. If you manage this trade properly and exit the trade at or near expiration the most you could lose is the $375 you paid for the structure.
2. Put Spread
- A put spread would be the mirror image of a call spread. For reference, the 5240-5220 put spread, which is the same distance from the current price of the underlying futures contract, could be purchased for eight tics or $400. Generally speaking, puts are slightly more expensive than calls that are equidistant from the underlying due to a pattern of traders and investors seeking downside protection.
3. Non-Directional Trade
If a trader believes that the magnitude of a coming event is being underestimated by the market, there are several option strategies they could use to express their thesis.
- Buying a “strangle” is often a cheaper alternative to a straddle (buying the same strike put and call). A strangle is buying a put and buying a call, but not at the same strike price. A standard strangle would involve a call and a put roughly equidistant from the underlying. In this case, we will look at the April week two Friday 5320(call)-5240(put) strangle, with futures trading in the middle at 5280.
- This structure can be bought for approximately 66 tics or $3,300. For this example, this structure would have 18 days until expiration and it would also encompass several significant economic releases. For this trade to be profitable, the underlying instrument would have to move either 66 tics below the put (5174) or 66 tics above the call (5386). Beyond those levels, there is no cap on potential gains.
Regardless of how events may shape the November election, and the perceived risks leading up to it, managing risk in equities markets will be a key part of the plan for most traders. As we’ve seen in recent years, equity options are likely to be an important tool in executing their strategy.