Question: How can you trade a “too close to call” election?
Answer: Execute a volatility play with the use of straddles and strangles.
Options premium consists of two components: Intrinsic value and time value. Intrinsic value is the in-the-money portion of the premium. For instance, with the gold exchange-traded fund (ETF), GLD, October 158 calls trading at $4.50 with GLD trading at $159.10, there is $1.10 that is in-the-money. This portion of the premium is not affected by the passage of time or traders’ expectations. The $3.40 portion of the premium is affected by both of those factors and is called time value. Intrinsic value also is known as expiration value because only the in-the-money portion counts, or survives, at expiration.
Events that affect time value include earnings reports, crop reports and Food and Drug Administration announcements. Until the results of those events are released, time value generally remains at an abnormally high level. Once the results are known, there is a big drop in the time value that is embedded in the options premium. These events in the future represent unknowns that can have a large effect on value; the less time and fewer events that weigh on price, the lower the theta, or time value.
One also needs to know the difference between historical volatility and implied volatility. Historical volatility relates to the movement in the underlying instrument (stock, ETF, futures contract, index) to date. Implied volatility is the indication of the future movement in the underlying instrument based upon the price level of the options currently traded. For instance, if the Hewlett-Packard (HPQ) September 19 straddle was trading for $2.00 with four weeks until expiration and HPQ was trading at $19, the options would imply that HPQ would trade in the $17-$21 range over the next four weeks. You then back in these numbers and come up with the number for implied volatility.
The upcoming presidential election has some similarities and dissimilarities to the aforementioned events. A great deal of uncertainty will be eliminated after the election results. The major difference is that there are no daily tracking polls that indicate the result in the earnings for IBM.
So what are the chances of President Barack Obama being re-elected? The website Intrade.com gives him a 55.7% chance of winning re-election as of this writing. On the other hand, most polls have the election as a dead heat or favor one side by a slim percentage within the margin of error. It appears as though it will be a very close election.
As of Sept. 5, the SPDR ETF (SPY) is trading at $140.98. The September 141 calls have an implied volatility of 13.6, the October 141 calls of 14.8 and the November 141 calls of 16.3. The CBOE Volatility Index (VIX) futures for September, October and November are 18.50, 20.00 and 22.35 with the VIX at 17.60. The VIX derives its price from the time value that is embedded in SPX options. The VIX is at an abnormally low level to begin with, but the election is influencing the pricing of the November options heavily as well.
Purchasing the SPY November 141 Straddle at $8.40 would give a trader an upside breakeven point of $149.40 and a downside breakeven point of $132.60. The SPY had a low of $129.07 and a high of $142.18 over the previous 10 weeks. While election results alone could make that straddle a winner, there are ways for a trader to narrow the size of the breakout necessary for this strategy to be profitable.
The SPY October 137 puts are at $2.00 bid while the October 145 calls are $0.94 bid. If SPY remains between 137 and 145, the SPY strangle would expire worthless and the new cost basis of the trade would be $5.46 with 25 days left until expiration. At this time traders can choose to sell additional options against their straddle or let it ride. The ideal price points at October expiration would be either 145 or 137. If SPY blows past 137 or 145, the loss would be limited to $1.46 (see “A profitable platform”).
Although November implied volatility is much higher than that of the preceding months, it still is relatively low. Going long November volatility while shorting the nearer-term volatility could be the way to go.
Dan Keegan is an instructor with the Chicago School of Trading. Reach him at firstname.lastname@example.org.