Risk surrounding the US election is reaching unprecedented levels, as measured by the options market. Head of Global Asset Allocation Ashwin Alankar explains why options prices are rising and why going long volatility may have the potential to benefit investors.
With the US election nearing, prices for options that expire in November and December have started to trade at relative highs, suggesting the election has become a significant risk event.
Even with Democratic nominee Joe Biden leading in the polls, the options-implied attractiveness of assets that could outperform under a Biden administration and those under a Trump administration is evenly split.
Going long volatility may reduce the impact of market gyrations associated with the election, as well as volatility caused by other risk events, such as the prospects for fiscal stimulus in the US and COVID-19 vaccine development.
Ashwin Alankar: The markets – even though you may not notice it from the cash markets – are actually very much in tune and very much pricing in election risk. The way you can see that is if you look at the price of options that expire November/December, they are at a record price relative to the prices of options expiring in October or options expiring in January. And given this pricing, what the option markets and volatility markets are indicating is that the 2020 US presidential election, as it stands right now, is the greatest event risk in the history of the markets. So, the markets are far from ignoring election risk. In fact, they are placing a record importance on the election and the uncertainty surrounding the election.
I think it really has to do with the very fundamental reason that you have two very different ideologies. It is a reflection of how divided the US is, how divided the political picture in the US is. There is no middle ground; so, this is an election about two fundamentally different ideologies. And so, when you are in this spectrum of polar opposites, if one candidate wins, a certain environment is going to unfold, which is going to be the polar opposite than if the other candidate wins. So, this is really pricing in the breadth and the wide divergence between the [Joe] Biden platform or the Democratic platform and the Republican or [Donald] Trump platform.
So the uncertainty of the market is very, very high and this is a function of the large ideological differences in both of their platforms, but it is also a function of the fact that, given what happened with Brexit, given what happened with the 2016 election, the markets likely are placing less importance and less reliability on polls. So even though polls are showing a much greater margin of victory for Biden versus Hillary Clinton at the same point back in 2016, I think the markets are discounting this and the markets are believing that the race is much tighter than the public polls and public consensus reflects. And we are actually seeing that in how the option market is pricing in sectors and stocks which should do better under a Biden win versus a Trump win. And right now, the option market is neither showing a greater attractiveness for those assets which should do better under a Biden win versus under a Trump win. The closer you are to a coin flip, the more uncertainty surrounds the election and what is going to happen post the election. And I think all these factors are playing a very impactful role in the level of risk that the market is pricing surrounding the November 3 election date.
I do want to emphasise that there are other risks besides the election risk here that are very important to consider and very important not to ignore, which is the risk of fiscal stimulus not coming through; and also, vaccine risk – that science is slowing down a little bit. These are risks that the market is laser-focused on, and so we should not be surprised if we see more trials and tribulations hitting the capital markets that aren't explained by the election, because we are in uncertain times; uncertain on the political front, uncertain on the social front and uncertain on the public health front. So, it is kind of a triple whammy right now.
These are the views of the author at the time of publication and are subject to change.
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