The Striking Price
A Guide to Hedging Election Outcomes
Need to protect yourself against, say, a Trump victory? Take out an insurance policy of options.
By STEVEN SOSNICK
Saturday, October 1, 2016
Last week over dinner, a money-manager friend asked me for my opinion on hedging his exposure to the election. His thesis was that a Clinton victory would continue the market's status quo, while a Trump win would bring a host of uncertain outcomes.
Since Mr. Market hates uncertainty, my friend was purchasing put options on the SPDR S&P 500 exchange-traded fund (ticker: SPY) in the hope they would protect his portfolio from a potential rise in volatility and a market correction after a Trump victory. He rued that he was likely to lose the cost of his protective puts because he believed there was a higher likelihood of a Clinton victory. I responded, “Isn't that what you hope for when you buy insurance?” Insurance is the one product everyone buys, but hopes never to use.
Some market professionals view a Trump triumph as the sort of low-probability, high-outcome event that is best protected by insurance. While there are many plausible scenarios about the market reaction to the election, the general view was summed up by Blackstone Group's president, Tony James, when he reportedly said he wouldn't know how to discount the market if Trump won. If a key executive at a multibillion-dollar money manager professes such uncertainty, can the average investor remain sanguine?
It is crucially important to keep your personal views outside the hedging calculus. The market cares little about individual opinions. It's more productive to think broadly in terms of expectations and outcomes and use them to make detached decisions.
Some may wonder why this column has focused on the risks of a Trump victory. An even more unlikely outcome that could roil the financial world would occur if Clinton's coattails turned both houses of Congress Democratic. Your preference as to outcome is irrelevant. What matters is whether it could occur and what would happen to the market if it did.
One benefit of this approach is that it's usually much cheaper to hedge an out-of-consensus risk. The price of protective options is directly related to the market's perceptions of the likelihood and magnitude of the potential outcome. It can be relatively inexpensive to hedge event risk if the market views it as highly unlikely.
My friend saw the potential for as much as a 10% correction to broader markets and a corresponding uptick in the CBOE Volatility Index, or VIX, if Trump won. He saw no reason to otherwise lighten up his market exposure, especially since he tends to take concentrated positions in carefully researched stocks.
Our conversation focused on SPY 200 strike puts expiring on Nov. 18, 2016. Although there is now an expiration date closer to the election, the extra week could prove beneficial if the election results prove to be uncertain. The strike is somewhat less than my friend's anticipated 10% move, but trying to match your strike too precisely runs the risk of the option being just out of the money at expiration, even if you predict correctly.
The market seems to be pricing in very little election chaos. The implied volatility of the 200 puts that expire on Nov. 18 was recently about 19. That compares to about 18.5 for the same strike puts that expire on Nov. 4, the Friday before the election. Each contract purchased for roughly $1 could potentially protect as much as $20,000 of equity exposure. If investors expect even a 5% chance of a truly unfavorable outcome, the trade could become profitable.
I happened to be dining with the same group of friends when the Brexit results were being released. Prior to that evening there was a fairly strong consensus that Remain would win. Of course, the consensus was wrong. After the presidential election, my friend doesn't want to risk having his portfolio caught off-guard. Do you?
Reprinted by permission of Barron's Online, © 2016 Dow Jones & Company, Inc. All Rights Reserved Worldwide.
The views expressed in the above papers and articles are solely those of the author of the article, and do not necessarily reflect the views of OIC; the information presented is not intended to constitute investment advice or recommendations to purchase or sell securities of any company; and the information presented is based upon particular events that may or may not recur in the future.
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