Recent political drama has created interesting potential trades for investors utilizing options. The outlook for control of the House of Representatives after the November elections has become less certain, as evidenced by the Tradesports.com GOP. HOUSE.2006 contract (see “A coin flip”), which places the odds for GOP control at 48% as of Oct. 6, down from highs in excess of 85% a year ago. Also, at the Iowa Electronic Market from the University of Iowa, the chances of Republicans maintaining control of both houses is even lower. This degree of uncertainty creates the potential for a significant market response to the election.
For a historical perspective of electoral uncertainty, look to the midterm election of 1930. In the run-up to the 1930 election, the Republican Party was unpopular due to the onset of the Great Depression. In the Senate, the Republicans held an eight-seat advantage over the Democrats. After the election the Democrats picked up all eight of those seats. The Senate was still technically controlled by the Republicans by virtue of the vice presidential tie-breaker, a scenario that we have seen in the past decade. In the House, the Republicans lost a net of 52 seats to the Democrats, but retained the majority by the razor thin margin of one until 19 representatives died. After special elections to fill the vacant seats, the Democrats took control of the House.
While not a bet we would make, the advent of both parties creating “safe” districts with incumbents almost always winning, unless they are caught making inappropriate contact with a House page, brings this scenario into play.
That said, our opinion as to the outcome or its directional impact on markets is not relevant in structuring a trade.
We see the biggest opportunities created by the uncertainty in U.S. stock indexes and the dollar. Both rely heavily on U.S. political outcomes and have reacted strongly in recent years once those outcomes were determined.
We recommend the purchase of the front month strangles utilizing 10-delta calls and puts in either the EUR/USD cross or the S&P 500. This is a long volatility strategy that will profit from a meaningful “up” or “down” move in reaction to the election results while not costing a lot.
The 10-delta option strangle achieves this objective with a favorable gamma/theta ratio, while additionally remaining within the realm of liquidly traded options. The objective is a reward to cost ratio of at least 3:1 for a one-day move larger than a historic two standard deviation probability. Given the present degree of uncertainty, such a move is likely to occur based on historical market perspectives. The trades need not be executed until one or two days prior to the election to avoid intermediate theta decay with the intention of unwinding positions after the election.
If the election was held tomorrow, the December S&P 500 contract would have closed at 1358 and the December euro future would have closed at 126.56. In the S&P we would have been buyers of the October expiration, priced off of the December contract, with a 1320 put and 1390 call, which would pay 2.7 S&P points, or $675, per strangle on the close. Most of the $750 outlay will be recouped the following day if no major market move has occurred. The net worst-case cost of this position will be under $150. If a greater than two sigma move occurs, the profit will exceed $450, satisfying our 3:1 minimum ratio requirement.
In the currency we would be buyers of the November expiration, priced off of the December contract, with a 124.50 put and 128.50 call, which would pay a total of 54 ticks or $675 per strangle. Again this initial outlay will be largely recouped if the position is closed after election day. The worst-case net cost will not exceed $125, and the minimum profit from a two sigma move will be $400, which is better than the 3:1 ratio required.
The exit strategy is very flexible. The strategy described calls for the position to be initiated election day and closed the following day. However, if new information indicates that holding one or both legs of the strangles is worthwhile, then that will be done.
Donald A. Newell, is principal and head trader of Chicago based CTA Quiddity LLC., which he founded in 2002, and worked as a market maker on the floor of the Chicago Board Options Exchange for eight years.
