Likely voters probably already have opinions about the way they'll vote in midterm elections this November. What about options traders?
As this article is roughed out, it's about 63 days before November's expiration for equities. For some traders of strategies utilizing the regular options cycles, as opposed to Weeklys, it's time to begin entering November's positions. For others, preferred entry times are still weeks away. Timing of entries can be important, but traders should probably put other decisions first. November's expiration comes after the midterm elections, so traders should probably factor in what they believe will happen in those elections, the likely market result, and the expected impact on implied volatilities leading into and then immediately after the elections.
While I don't believe that traders should abandon their well-back-tested trading plans due to an election cycle, I do believe that options traders should probably be aware, in particular, of the impact of such large events on implied volatilities. I always expect to see the same kind of effect we see leading into an important earnings report for a market-moving company or an FOMC event when a change is expected. What is that effect? Ahead of the event, implied volatilities often rise, decay of options often stalls, skews often change. Then implied volatilities can collapse after the result is known unless the resulting market action is a steep decline or immensely challenging price volatility.
VIX Leading into the 2012 Elections:
Remember that my articles are roughed out days to a couple of weeks before publication, so charts are not up-to-date.
Current VIX Level:
We know that the spot VIX value does not exactly echo what we're seeing in the options involved in our SPX-related or other trades, but it's possibly the most widely available and most easily accessible proxy for what might happen for many options traders. In 2012, the VIX did begin rising in early October into the election time frame. Then, after a period of volatility in VIX levels, it dropped. As of this writing on September 18, VIX levels are in the low range but not as low as they were in the summer. Is it possible that they're going to follow the pattern of 2012, dropping into early October and then rising?
We have no guarantees, but we must be aware this VIX rise into the elections, beginning now or early in October, is a possibility. Particularly when in the early weeks of trading iron condors or butterflies, a rapid expansion in implied volatilities is at least as great a threat to a trade's health as a sharp price movement and maybe more.
Hypothetical Four-Contract SPX Iron Condor, Graph by OptionNet Explorer:
Notice that in this traditional setup for a four-contract iron condor, the delta--for newbies, a measure of how much a trade's profit or loss is impacted by a change in the underlying's price--is a rather flat -5.52. However, Vega--a measure of how much a trade's profit or loss is impacted by a change in the implied volatility--is a much more impactful -136.78. Because it's negative, the trade's profit is hurt by each one-point rise in implied volatilities.
Theoretical Profit-and-Loss Change if Implied Volatilities Rise Three Points with No Price Change:
Theoretically, a sharp rise in implied volatilities would hurt the trade profit-and-loss line even if price didn't move much. Some traders theorize that they could wait out such effects as long as price stayed well centered in this expiration graph. I've thought so myself . . . in the past. The problem is that this effect can force adjustments sooner, and at more disadvantageous prices, than would otherwise be required.
The effect could be compared to a fat-fingered order that resulted in a really bad entry into a trade, and you've got those initial losses to make up before you ever see any possibility of a profit.
If you've traded through such events previously, you know what works best for you. For newbies, it's time to form an opinion--not about the election and maybe not even about which results will be "good" for the market and which "bad"--but about what will happen to implied volatilities leading into the election and immediately afterward. Look at price charts differently, too. Don't think about where they're going to go, but where they're vulnerable to going, in either direction.
Do you need a price hedge? A volatility hedge? If your opinion is that equity prices are going to rise right into November's expiration with nary a blip, you may not need a volatility hedge, and you may instead need to be thinking about a price hedge against a too-rapid rise. If it's your opinion that prices are topping out and are due for a run-of-the-mill pullback coincident with a minor rise in implied volatilities, perhaps you just manage the trade as usual. However, if you fear the recently concluded FOMC meeting was the last without a change in wording, and that equity prices are due for more than a run-of-the-mill pullback, and that big money may take money off the table ahead of the election, you may need a volatility hedge. A long OTM put or "long" complex position such as a debit spread will help hedge against a rise in volatility. Just be careful that you don't swamp the position while buying such a hedge. For example, in our four-contract SPX iron condor example, buying a long SPX put may be too expensive and may undercut the trade's potential profit too much. Perhaps for you, it's enough of a hedge to lower the trade's number of contracts to four, with sizing down being an acceptable way of hedging risk. For others, buying an SPY put might be one way of hedging against a rise in volatility.
Some traders will be employing VIX options for their hedges. Because of the difference in the behavior of VIX options and spot VIX prices and the difference in expirations of VIX and equity options, I don't do that. I can't speak about it with any authority other than to warn you to be sure you know what you're doing before you leap into that kind of trade.
Calendar traders have special considerations since VIX options are priced based on futures 30 days out. The idea for calendars is that the front-month's sold option will decay faster than the back-month trade. However, if the front-month's implied volatilities rise into the election period (NOV's) but most options traders expect any effect due to elections to be short-lived and over with by the back month's expiration (DEC or later), then you may not get the desired effect. The sold options may not decay as expected.
Whatever your political persuasions or your preference in trading styles, it's not time to panic. Our nation is going to survive, no matter what the results, and Democratic and Republican neighbors will still wave to each other when they're mowing lawns or shoveling snow, whichever party takes the Senate. At least the sane ones will. It's just time to think calmly about your approach to your November trades.