Investor Election Jitters Starting to Show Up in Stock Options

(Bloomberg) -- With U.S. stocks having roared back from the pandemic selloff, it may seem like investors are sanguine about what lies ahead. A closer look, however, shows traders pricing in a lot of risk around election time.

Options investors are piling into hedges against losses around the Nov. 3 presidential vote. The anxiety is laid bare by the premium on S&P 500 contracts that expire around that date.

Typically, traders price higher volatility in longer-dated options than they do on shorter-dated ones, given that it’s harder to predict what’s going to happen the further away it is. That usually produces an upward-sloping curve. Right now, however, the implied volatility for the S&P 500 peaks at the five-month point, right around the election.

It isn’t possible to discern exactly what traders are concerned about at election time, but there’s no shortage of possibilities. Democratic nominee Joe Biden is running ahead of President Donald Trump in polls, and some investors may be betting he’d be more likely to raise corporate taxes and bolster regulation. There’s also some concern -- at least on the margins -- that the election could be chaotic and see accusations of voter fraud or other cheating that undermine confidence in American democracy.

Anyone who witnessed the 2016 election could testify to the volatile market reaction to that event. Futures on the S&P 500 initially tumbled overnight on Trump’s surprise victory before bouncing back and staging a rally the next day.

The S&P 500’s options are implying a move of 4.2% on election day, compared with an average swing of 2.9% after the previous three presidential votes, data compiled by Bank of America showed.

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One threat from a Democratic win is the party’s proposal to partially roll back the tax cuts Trump enacted in 2017. Such a reversal, according to Goldman Sachs estimates, would shave about $20 a share from S&P 500 earnings for 2021 to $150.

“As Biden’s polling strength grows, vol markets are back to pricing in a material election premium for November,” BofA strategists including Nitin Saksena wrote in a note. “A potential victory by Joe Biden, and to a greater extent, a ‘Democratic sweep,’ are generally considered more market-unfriendly outcomes.”

While that’s often the conventional wisdom, recent trading patterns don’t necessarily back it up. The S&P 500 has gained roughly 5% since the end of May while Trump’s odds of winning have dipped 5 percentage points to 45% over the same period, according to PredictIt.

Whatever the driver, concern around election time can also be seen in VIX futures that are tied to the Cboe Volatility Index. Across various expirations, contracts have demonstrated a decline in implied volatility since April. But the October contract -- whose underlying options will encompass the early Nov. 3 vote at expiry -- has seen the smallest retracement.

As a result, a strategy that sells VIX futures pre- and post-election and buy VIX futures for the event have gotten much more expensive, data from BofA showed.

“The return of the election risk premium is real and significant,” Saksena said.

©2020 Bloomberg L.P.