Election Volatility

Sophisticated traders, many of whom use forward-looking financial instruments such as futures and options, are placing bets on the state of volatility leading up to and following the election. Along with the onslaught of catalysts such as the COVID crisis and resulting economic disruption, these bets have helped shape the futures curve and naturally caught the attention of the business press. For a look at what the Wall Street Journal had to say about expected volatility on and after the election itself, click HERE. After weeks of flattening, the VIX term structure is once again in backwardation as election and near-term catalyst are fostering interest in hedging with November in particular trading at very rich levels: See below

While this large bid to front month volatility may seem like the obvious and natural course heading into an election, we actually saw the term structure for 2016’s election take on the exact opposite shape. One week ahead of election night, the VIX futures curve was in near perfect contango, with spot VIX trading just slightly over the November future: See below

For the most part, in the normal course of trading activity, open interest on call options for the VIX far out ways open interest on puts. A buyer of a VIX call is looking for a hedge or to make outright positive P&L with the price-rise of volatility, often to offset losses in the market. A buyer of a put is expecting the price of volatility to contract which generally coincides with a rising market. As we head into the 2020 election we are seeing an interesting setup with put open interest greater than call open interest (3.264mm contracts vs 3.066mm contracts). This of course was not what we saw in 2016 as the gap between put and call open interest was heavily skewed toward calls. In fact, over the past five years, Put Open Interest > Call Open Interest has only happened a handful of times all of which have occurred in 2020.

Looking at the full board of open interest on VIX options, 8 of the 10 largest lines are puts.

It is unclear why sophisticated investors remained calm in 2016 leading up to the election and are today quite anxious, perhaps having more to do with the catalysts than the election itself. Adding to the curious shape of the curve based on current positioning, it would appear that traders, investors and speculators are expecting a strong contraction in volatility post-election. Bottom line (as depicted in the first chart) there is an expectation of high volatility in the November contracts which give way to reducing volatility in the December contract and beyond. There is clearly an expectation of a post-election calm.

Of course the current view of volatility may once again change and post-election standard deviations may in fact be larger than those directly around the election. The impact of uncertainty and fear will be reflected by the price of volatility as it has been since 1993 when the VIX was developed by Vanderbilt University’s Professor Robert E. Whaley.

So what does this mean to the financial professional advising clients? Stay the course and ignore what could be meaningful market gyrations; or reduce overall exposure to the equity market by moving to cash or bonds; or apply a hedge using options and/or futures directly or through certain volatility ETFs? An interesting perspective on this conundrum appeared in Advisor Perspectives a couple weeks ago and may shed some light on the complexities and skills needed to navigate market volatility using the volatility market as a hedge. Click HERE to read.