How options traders are preparing for election volatility

As the 2024 U.S. presidential election approaches, financial markets are preparing for what could be a highly volatile rest of the year. With former President Donald Trump and current Vice President Kamala Harris set to engage in their first debate next Tuesday, it's crucial for traders and investors to understand the potential market implications and explore strategic options for navigating this period.

In recent years, options trading has experienced substantial growth, driven by a variety of factors that have made this financial instrument more accessible and appealing to a broader audience. According to data from the Chicago Mercantile Exchange (CME), the volume of equity index options contracts surged from approximately 30 million contracts in Q1 2015 to nearly 100 million contracts by Q4 2023. The COVID-19 pandemic significantly accelerated this trend, with average daily volumes (ADV) in options trading seeing a 51% increase in 2020 compared to 2019. As we approach the November elections, options can serve as a critical tool for managing stock market risk. Regardless of the election's outcome or the anticipated risks leading up to it, effectively managing market exposure will be a key focus for traders.

Historical data suggests that U.S. elections often bring heightened market volatility, and this year is no exception. One of the key indicators of expected market volatility is the S&P 500 VIX. Futures for the S&P 500 VIX in October and November have been trading at a higher premium compared to December, suggesting that traders are predicting heightened volatility leading up to and following the November 5th Election Day. Investors can also monitor S&P 500 Index options for insights into market sentiment during this period.

The chart below indicates that during U.S. presidential elections, the stock market tends to experience some volatility, but in the long run, regardless of which party is in power, the market generally trends upwards. This reflects investor confidence in the economic outlook and expectations for policy stability. In election years (blue line), the market's average performance is typically stronger compared to non-election years (pink line). When there is a political party change (green line), market volatility tends to increase around the election period, but the market often experiences a significant rebound post-election. In case where there is no political party change (purple line), the market performance remains relatively stable, yet still outperforms the average of non-election years.

Strong Bullish Sentiment: The trader is highly optimistic about the market's future, likely anticipating a substantial rally in the S&P 500. This could be driven by expectations of a favorable election outcome, supportive economic policies, or other bullish catalysts.

Long-Term View: By choosing a call option with a distant expiration date, the trader is expressing confidence that even if short-term volatility occurs, the market will trend significantly higher in the long run.

Leverage: A deep in-the-money call option provides leveraged exposure to the S&P 500's movements, amplifying potential gains from upward price movements while limiting downside risk to the premium paid.

When to use long in-the-money call: This strategy is best suited for investors who have a strong conviction that the market will rally significantly over the long term. Investors who are willing to hold the options for an extended period, weathering short-term volatility for potentially higher long-term gains, will find this strategy valuable.