Traders brace for haywire markets around presidential election

The presidential election is three months away, but some traders are preparing for the possibility that prolonged political uncertainty will stoke stock-market mayhem.

The investors are going beyond the normal hedging ahead of a potential change in power in Washington. Instead they are betting on volatility and a possible market tumble later in the year. Among their concerns: President Trump could try to delay the election or disrupt mail-in voting, as well as the chance that a result remains unclear for weeks after polls close.

The election worries amplify existing concerns about the weak economy, a possible second wave of coronavirus infections in the fall and the highflying market. The bearish bet is that turmoil around the election hits the already fragile economy as the cooler months bring on more infections, all hitting the stock market that is priced for a recovery. The S&P 500 has advanced 4.4% this year to close at 3372.85 Friday. Its recovery since its March lows has powered the best 100-day stretch since 1933.

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Eric Metz, chief investment officer at investment firm SpiderRock Advisors, has tapped a stock-options trade for clients that would profit if the S&P 500 drops up to 25% from its current level through early next year. The hedge involves buying one bearish put option tied to the S&P 500 while selling another. Concerns about the broader economy and the stock market's recent rally also are fueling interest in such trades, he said.

"We're focusing on January," said Mr. Metz. "Giving yourself a little bit more time...will prove prudent for all the unforeseen or unknown things that could happen."

The main driver of the market right now is the economy and uncertainty of a new stimulus package in Washington, which could hurt the slow recovery recently seen in retail sales and jobs. Next week, traders will be tracking new data on jobless claims and home sales, though many are expecting light trading volumes through the end of the month.

Paul Britton, founder of Capstone Investment Advisors LLC, said his firm has been using derivatives tied to a popular gauge of expected volatility, the Cboe Volatility Index, or the VIX, as well as options contracts, to bet on volatility through the end of the year in one of its strategies. His clients, which include endowments and pension funds, have sought insurance-like trades to protect against a downturn.

"You always get this interest ahead of an election," said Mr. Britton, whose firm is one of the biggest specializing in trading volatility, overseeing roughly $7 billion in assets. "You've got a greater interest because of the added uncertainty."

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Bridgewater Associates, the giant hedge fund with $140 billion in assets, told clients last month it believes there is a risk there will be no clear election winner. "The real uncertainty that could confront investors is if there is material concern over the legitimacy of the process to decide a winner," Bridgewater told clients. "Given President Donald Trump's personality, his statements about the likelihood of fraud, and the relatively untested and unclear process for reaching resolution, it is a possibility in our minds."

A spokesman for Bridgewater declined to comment further.

Some of the largest options positions outstanding on the S&P 500 would profit if the index plunges through December, according to data provider Trade Alert. These include bearish put option contracts pegged to a strike -- or the level at which the contracts can be exercised -- of 2500 or 2000, at least a 26% drop from Friday's closing level of 3372.85.

Call options give the right to buy shares at a specific price, later in time. Put options confer the right to sell. Traders can tap options to make directional bets or hedge portfolios.

To profit from a rocky presidential election, RBC Capital Markets recently recommended investors buy bullish options that expire in January on one of the biggest exchange-traded funds tracking gold. Goldman Sachs Group Inc. analysts said in a July note to clients that they preferred putting on hedges that expire in December because of the prospect of delayed election results, pointing to the 2000 contest between Democrat Al Gore and George W. Bush when the fate of the race was unclear until December.

Markets tend to be volatile ahead of elections, and October and November tend to be the wildest months of the year anyway. The VIX has risen an average of about four points ahead of the past seven elections since its inception.

Fear surrounding the election appears even more intense this time around. Investors are paying more for VIX futures tied to October than September than they have in the past four election cycles going back to 2004, according to Stuart Kaiser, head of equity derivatives research at UBS Group AG. This extra premium is more than double what it has been historically, UBS data shows. These derivatives cover the coming Nov. 3 election.

The anxiety is evident in the market for VIX derivatives going out to January, well after election day. Typically, futures contracts that expire later in time are priced higher than those expiring in earlier months as investors brace for the unknown. That relationship has been slightly inverted around the beginning of the year, indicating traders expect more volatility around January than they do in the following months.

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Meanwhile, gold prices have surged to records recently, driven higher by investors nervous about the world economy. Some of the largest options positions outstanding tied to the $78 billion SPDR Gold Trust are bullish calls expiring in January, a bet that the exchange-traded fund will jump another 10% toward $200 or $235, Trade Alert data show.

Jack Ablin, chief investment officer at Cresset Capital in Chicago, says he is searching for ways to hedge against postelection chaos. Mr. Ablin is focusing on structured notes, which are customized investments sold by banks that promise to protect the original investment while providing some potential upside. There can be high fees and other restrictions related to these products, however.

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He is also buying a series of put contracts, or options that figure to profit if the market falls, traded on the Cboe Global Markets Inc., while selling contracts that bet on a market climb.

"We're selling upside opportunity in exchange for downside protection," Mr. Ablin says. "The possibility of a contested election could wreak havoc in both the country and our financial markets, as Americans question the viability of our nation's democratic process."