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Election Uncertainty Could Ramp Up Stock Volatility

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September 27, 2016
Election Uncertainty Could Ramp Up Stock Volatility

The U.S. presidential showdown is just getting started. Last night's debate between U.S. presidential candidates Hillary Clinton (D) and Donald Trump (R) was the first of four debates ahead of the Nov. 8 election.

Investors may want to consider positioning themselves for increased levels of stock market volatility.

Recent polls show the race for president is tightening, which could inject higher levels of volatility into stock market in the weeks ahead. The latest RealClear Politics average of polls has Clinton with a 2.5 percentage point lead, with Clinton at 46.2% and Trump at 43.7%.

"This is the first time in a long time that the focus on the Federal Reserve is moving to the backseat," says JJ Kinahan, chief market strategist at TD Ameritrade. "The Fed is still out there and the timing of interest rate hikes are still a big unknown, but attention is turning to the presidential race and the outcome of the House and Senate races."

History Paves The Way

Although the past cannot predict the future, historical numbers seem to back up the potential risk for heightened market volatility between now and the Nov. 8 election. Sam Stovall, managing director at S&P Capital IQ crunched the numbers and found that since 1945, the S&P 500 has declined an average of 3.3% in a presidential election year when the incumbent can't run for re-election. That compares to a 10.2% gain when the incumbent has run for re-election, Stovall says.

But, wait. There's more.

October, of course, has the ugly moniker of "crash month" notorious for the October 1929 crash that led to the Great Depression. Other notable October stock market events include:

·      Black Monday in October 1987 (22.61% drop in Dow),

·      mini-crash in October 1989,

·      October 1997 crash (Asian financial crisis).

Presidential election year or not, Stovall's number crunching found that October has the greatest number of single-day 1% moves in the S&P 500 since 1952 and is the most volatile month of the year.

Big Picture: Donkey versus Elephant

No matter your political stripe, it is interesting to take a look at some economic history facts. WalletHub’s analysts have compared the economic performance of the U.S. under both Democratic and Republican control to objectively answer an important question: Which party is better for the economy?

Here is a snapshot of WalletHub's findings:

1.     Overall, the economy has performed best under the combination of a Democratic presidency and Republican Congress.

2.     The stock market has performed best under a Democratic presidency and Republican Congress, with the S&P 500 producing an average annual return of 17.03 percent, and worst under a Republican presidency and divided Congress, with an average annual return of 3.28 percent.

Investor Strategy

Stock market volatility has increased slightly in recent trading days. The CBOE's Volatility Index, or VIX, bumped up to 13.64 on Monday, up slightly from its 52-week low at 11.02.

Do current low but rising levels of volatility suggest the calm before the storm? As volatility increases, there is greater demand for portfolio protection and increased potential for price movement, Kinahan says.

Now may be a good time to evaluate your portfolio. Consider if you need to buy some protection, Kinahan says. Traders might also consider protection for current individual stock holdings.

Education 101

One approach to express a volatility "opinion" in a stock that you are already holding is a calendar spread. For instance, consider “stock XYZ” that’s now trading around $112. An investor might sell Oct 2016 105 puts and buy Jan 2017 105 puts. In this case, they would be selling near-term volatility and buying long-term volatility. TD Ameritrade clients can analyze this idea via the Trade Tab in the thinkorswim® platform. See Figure 1 below.

FIGURE 1: CHARTING VOLATILITY

To create the chart, go to the Trade tab in thinkorswim> create the calendar position > in the order entry box right click on the order and select “Analyze Trade” in the drop down.  This will take you to the Analyze tab, the Risk Profile tab will have the chart up showing your profit or loss (P/L) at different price levels. Not a recommendation. For illustrative purposes only. Past performance does not guarantee future results.

Of course, there are also risks to this strategy, which can include:

  • Early assignment of the short option
  • Multi-leg option strategies can entail substantial transaction costs, including multiple commissions
  • Loss of the entire amount paid for the spread.

Parting thoughts? "Volatile markets are not a time to be afraid. Use it to your advantage," Kinahan says.

Traders often monitor the CBOE Volatility Index (VIX) as an overall "uncertainty" gauge for the broad market. The VIX measures the level of volatility in the S&P 500 (SPX) cash index, and is calculated through the value of out-of-the-money SPX index options.

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