Ways to Play the Election Year with Options
Election time is approaching. And after a nice calm summer where most investors are out on vacation, it’s time to get back to reality and get ready for a busy next few months in the investing world.
There have been many financial surprises in the markets this year, including one of the worst January bear surprises in recent history and the Brexit vote a couple of months ago. These types of events increase investor uncertainties, which ultimately raises volatility. Another important event is coming; the presidential election. And this means investors need to stay alert and be prepared for some volatility to come.
It is a given that presidential election years affect the market. Based on an MFS Investment Management research report on political control and market statistics from 1901 to 2016, the S&P 500 Index, on average, returned a total of 8.6% per year under Democratic presidents and Republican-led Congresses. Also, the S&P 500 Index gained about 7% per year when both the White House and Congress were run by the same political party.
After 1976, the worst S&P 500 Index returns we saw were in the 2000 election year with -9.1%, and in the 2008 election year with -37%.
Another thing to observe is that since 1928, the S&P 500 has dropped an average of 2.8% when the presidential election years do not have an incumbent president seeking reelection. On the other hand, when the president is seeking reelection, the S&P 500 had a 12.6% average return. One of the reasons why the markets returns are favorable when an incumbent is seeking reelection is the benefits of continuity, and perhaps more certainty, that come with it.
While these facts hold true, the performance of previous elections – whether they involve new candidates or incumbents seeking reelection – do not necessarily mean that same scenarios will happen this year or in future election periods. Since we all know that past returns do not equal future performance.
Take note that the market responds better to election developments with more predictable outcomes. We can expect that the markets will be uncertain all the way through November 2016. The very fact that we have a candidate with no political experience but business expertise, and another one with the political experience and less business authority – makes this election year one with few clues on how each of them may either help or hurt the stock market.
Election Candidate Influence on Different Sectors
Investors look at political parties to help them steer their investment decisions. Investors seem to look into party affiliations to get clues into which candidate can have a better impact on the market.
Economic proposals by the candidates can have an impact on how investors will build their portfolio this year. The effects of candidate’s values and proposals may not have an equal effect on all sectors, however. For example, we do know that the infrastructure industry is likely to thrive under both candidates given their expansion plans, especially Donald Trump given his real estate investing background. He is also likely to increase the budget for defense. This will be welcomed by aerospace and defense companies. However, Trump may be seen as more of a wild card given that a lot of uncertainty may be poured on Wall Street due to his previous lack of involvement in politics.
Hillary Clinton, on the other hand, has been in politics for a large chunk of her career and has ties with Wall Street, which could suggest that she will maintain the status quo for the financial sector. Even though she supports the idea of implementing stricter rules on hedge funds, it’s very unlikely she will completely change things around. So that’s a plus for financials.
She’s also in support of alternative and green energy. This suggests more subsidies for solar, wind and other renewable energy companies. This will drive that industry higher. Whereas, coal and all the major fossil fuels could experience downward pressure.
Making Decisions in a Volatile Election Year
When people sell stocks, fear rises. Volatility increases as well.
Too many domestic and international factors surprised us since the end of 2015. These include terrorist attacks, wars, decreasing oil prices, the Fed increasing interest rates last December and potentially doing it again soon, the Brexit vote, Yuan devaluation and other market catalysts have been affecting the markets recently.
If we are to look into the VIX (the volatility index), the figure has been hovering around 11 or 12 during the summer, with not much action. We had a spike in volatility during the China fallout in August of 2015, as well as in June 2016 following the Brexit vote. We also hit high on the VIX at the beginning of 2016, a couple of weeks after the Fed raised rates by 25 basis points. And now we see that volatility is at 2-year lows. Given this, volatility is likely to rise above its current level as we get closer to November – when investors will be more fearful and uncertain on how the change in government will affect the markets and their investment portfolios.
These are some examples of market volatility that affects investing decisions, which may be rational or not. After all, your success in investing will largely depend on you blend of financial goals, your time horizon, and risk appetite among other factors. It is not time for emotional investing.
One thing to keep in mind is that major lows in the stock market seemed to be more likely to occur in the midyear between congressional elections. That is two years before or after the presidential elections. Most of the time, bear markets are likely to happen during the first to second years of presidential terms.
Having said that, the main focus for investors should be to get ready for these uncertainties and then develop effective strategies that will provide the best benefits. Analyzing charts to see probable price levels is one way. Another would be to look into the different option trading strategies.
But before diving into that, you must understand the risks and ways to mitigate them investing in options. Some things you have to be well-informed of are time spreads, vertical spreads, and options Greeks, among many others, so you have the best possible knowledge and education to achieve your desired outcomes when trading and investing with options this election year. Smart option trading is one of the keys to investment success.
How Should We Trade Options Going into the Election Period Then?
To reiterate again, investors should always invest in accordance to their financial objectives, risk tolerance, and investment policy statement. However, if you’d like some ideas on how to protect your portfolio during uncertain times such as elections, we’ll talk about a couple here.
If we assume that volatility will increase in the next few months, we can conclude that option prices will increase. This is the case for both calls and puts because volatility is a major component of option pricing..
- Investors can take advantage of low option prices now given the current low volatility in the markets. For example,you can choose to buy protective puts to hedge some of your portfolio holdings for fairly cheap. The benefit is that your portfolio will be more protected and when/if volatility rises, the price of that put will increase in value.
- Another strategy investors can implement is waiting for volatility to begin rising, which in turn pushes option prices up. In this case, investors can take advantage by selling options at high prices. For example, you could sell some naked or cash-secured puts where the underlying is a stock that you wanted to earn, but it has been too expensive in the past. This way, you’re taking advantage of high put prices and earning premium, as well as potentially owning the stock you wanted at a cheaper price should it drop below the strike price by the expiry date.
- If you wait for the rise in volatility, you could also sell calls. Ideally, implementing the covered call strategy. This involves selling a call option where the underlying is a stock you currently own. This way you’re selling the call at an inflated premium given the high volatility and providing a lower breakeven price for your stock should the price tumble.
We always say that trading in options is a risky process, and without the right knowledge you might be making the wrong decisions that may lead you to losing some instead of gaining some. While historical facts can provide us a vision of how the markets may go given particular scenarios, we will always be in for a surprise as unforeseen events unfold.
No matter what your options investment strategies are, keep in mind that your decisions should be a cohesive process of your financial goals, risk appetite, time horizon, and other constraints. There is no better way to do it than to have a plan, which is your investment policy statement (IPS). You may be reading all there is to read about how you should behave this election year with respect to your portfolio, but if you don’t have a clear understanding of your IPS, you might just be making wrong decisions you won’t be able to take back.