This month represents the quadrennial opportunity for forex traders to trade the U.S. elections. The election campaign is fast approaching its apex and all markets are paying closer attention to the probabilities of the outcome. At hand is an interesting challenge for the forex trader. Are there trading strategies that can be aligned with different election outcomes? Are there strategies that do not require predicting the outcome? Before trading strategies can be outlined it is important to understand some of the dynamics that link the election outcome and currency price action.
Among the leading underlying factors affecting currency price movements will be market expectations regarding the U.S. economy. Consider the expected economic policy effects of each candidate and party. The Democrats in the past have been seen (whether true or not) as the party that offered a set of public policy programs that favor bigger government programs and increased taxation. Such increased spending might be considered stimulative in terms of growth, yet it also may be considered restrictive due to the effect of increasing the size of the public sector. Although Republican positions have been seen generally to focus on less taxation, there also are differing views on foreign trade. A Democratic victory implies a more protectionist “fair trade” approach that imposes increased taxes on corporations locating jobs abroad. The Republican approach in the past has favored more free trade.
In shaping a forex trading election strategy, traders need to first construct a decision tree with several branches. The first decision is to anticipate which party will win. The second task is to anticipate the magnitude of the victory. Will it be wide or narrow? The pollster John Zogby recently stated: “This contest is likely to be very close until the weekend before the election, then the dam may break and support may flood one way or the other.”
Third, and most challenging, is to anticipate expected market reaction to the winning outcome. The market reaction may hinge on whether the election is close, resulting in no mandate for change, or whether it will be a victory allowing one party to implement its economic agenda. A big Obama victory may be considered dollar negative based on expectations that big government and higher taxes will follow. A McCain victory may be considered dollar positive because of Republican policies with less market interference. Of course, recent experience doesn’t support these assumptions in terms of which party would grow Federal spending and support the dollar, though it could be argued that these assumptions persist regardless of evidence.
Traders can use plain vanilla options for playing a dollar outcome.
The election outcome, no matter who wins, is usually accompanied by a period of optimism where the country rallies around the new president-elect. This period of optimism would last until the first 100 days. During this period, the realities of difficult implementation of promises will lead to market pessimism. In contrast, an opposite outcome where the market is disappointed in the winner at first and then is impressed with the first 100 days also can be a scenario worth trading. These various scenarios provide an excellent opportunity to use plain vanilla forex options (see “FX scenarios for election”).
Traders believing that the election will have a big effect either way should consider a straddle where an at-the-money (ATM) option can be purchased. For those traders looking for an election momentum play, consider buying the EUR/USD and simultaneously selling the EUR/USD on election day, getting out as soon as the networks predict the result. An important confirming event for this tactic will be the reaction of the yen in response to the elections. If the market is disappointed and reads the election results as dollar bearish, that evening the USD/JPY pair would weaken. If the market response is bullish, the forex market’s risk appetite will increase by selling more yen and putting them into dollars, pushing the USD/JPY pair up. On election night, watch the reaction of the Asian and London sessions. Whether or not the forex trader considers any of these scenarios, one thing is for sure — watching the election returns will not be complete without watching the forex charts!
Abe Cofnas is the author of “The Forex Trading Course” and the upcoming “The Forex Options Trading Course” (Wiley). He holds a masters in public policy and a masters in political science from the University of California at Berkeley. Reach him at abe@secretsoftraders.com .
