Presidential elections can move markets, but how do they impact options trading specifically? Historically, presidential elections influence market volatility and investor sentiment, with unique effects on the options market. Traders should watch for options during election years and how they can adjust their strategies to navigate market uncertainty.
Historical Overview of Presidential Elections and Market Movements
Let’s examine how past presidential elections impacted market volatility, particularly in the lead-up to and following the election. We’ll examine a few examples of good and bad market movement in an election year and some market trends from recent US elections where volatility and political uncertainty played a key role.
Market Trends in Election Years
2008—Barack Obama vs. John McCain
When this election cycle happened, the United States was already in the middle of a recession that resulted in the housing bubble bursting. Going into election night, analysts predicted that stocks would recover no matter who was elected. Many saw the policies of both candidates as having what it would take to navigate the country through weak economic conditions. The risk of depression was already off the table, and much of the bad news from the previous year had already been factored into the current stock prices. Market trends during this election cycle were highly uneventful, considering all the chaos that occurred earlier in the year.
2016—Donald Trump vs. Hilary Clinton
Trump’s victory that night was highly unexpected. The market traded down around 900 points because everyone expected Clinton to win due to the polling and because many were uncertain about how Trump would do as a leader. Once investors were reassured over the next several weeks of his fiscal policies, the market began to return to normal, and then they really took off as investor confidence grew once more.
Volatility and Political Uncertainty
Markets do well when there’s a balance of power in government versus one-party control. This indicates that there won’t be massive legislative changes that could disrupt the marketplace. There’s political uncertainty in just about every election, creating market volatility, but the market becomes especially volatile when there’s the chance of one side or the other sweeping the elections and securing a majority in the executive and legislative branches of government.
Notable Examples of Market Movement
Look at specific instances when major political shifts led to market fluctuations. These can be good or bad market movements. To illustrate our point, we’ll give two examples, one good and one bad, to show how markets shift when political shake-ups occur.
Good Market Movement
Between November 8, 2016, and June 8, 2017, the S&P 500 rose a total of + 14.2 percent following President Donald Trump’s election. Traders were initially skeptical about Trump’s economic plans, and those doubts resulted in futures being traded down on election night by more than 900 points. Still, the stock market quickly jumped 6 percent between November 8 and mid-December as traders grew confident in Trump’s infrastructure plans and tax cut proposals.
Bad Market Movement
In the buildup to the Gulf War, between June 16, 1990, and October 11, 1990, the S&P 500 dropped a total of -20 percent. Stocks began freefalling after Saddam Hussein invaded Kuwait on August 2nd. Market confidence began to drop as the military conflict escalated, and the market declined until mid-October, when it began to rise once more as investors got used to the idea of the war and uncertainty began to clear up.
Key Factors that Influence Options Markets During Elections
What are some of the factors that significantly impact the options market during election years? It’s important to consider political policies pushed by those in power, the overall economic outline, market sentiment as displayed by the Volatility Index Movement, and how policies can impact sectors like financials, energy, and defense.
Political Policies and Economic Outlook
A primary focus for many investors is how much a candidate’s political policies will impact important sectors of the economy like tech, healthcare, and energy. Based on how confident investors are in the economic outlook for each candidate and their likelihood of winning, options prices can be drastically affected. Something mentioned earlier is that the market is more favorable when it looks like there will be political gridlock.
Volatility Index (VIX) Movement
The Volatility Index Movement (VIX) is a real-time market index that indicates the market’s expectations for volatility over the next 30 days. It’s commonly used to measure stress or fear levels in the market weeks before an election period. It’s a helpful tool for investors to gauge market sentiment based on how the polls are looking and the likely economic outlook based on who will most likely win. Based on the predicted expectations from VIX, options markets will fluctuate.
Sector-Specific Impacts
Specific sectors of the economy are most sensitive and vulnerable to political changes. Significant changes in these sectors can ultimately influence the market and options prices, believe it or not.
- Defense Sector: Whoever becomes President of the United States is the Command in Chief of the Armed Forces, so they oversee the military and make changes where they see fit. Major changes in defense sector spending or the allocation of troops, weapons, or resources can either bring confidence to traders or leave them with a negative outlook, depending on how option pricing is affected for companies in the defense sector.
- Energy Sector: Government policies directly influence access to the development or regulation of energy sources. This can lead to significant changes or impacts for energy companies based on the administration’s decisions on environmental standards, focusing on infrastructure, or the allocation of subsidies. It can also affect option pricing for companies in the energy sector.
- Financial Sector: Government and politicians have significant influence over monetary policy, regulations, taxation, etc. As a result, financial institutions like banks can be directly impacted by these decisions or policies, and they can affect options pricing for companies in the financial sector.
Volatility Spikes and Strategies for Options Traders
This section of our guide will explain volatility spikes, what they are, and why they matter to options trading strategies during election periods. Learn how to use straddles and strangles to profit from big price shake-ups in either direction or how the iron condor can be used to remain stable in the midst of unstable market conditions.
Why Volatility Spikes Matter
It’s known that heightened volatility affects options premiums and trading volume. One of the most significant effects of volatility on traders is that many will have to rebalance their portfolios and make asset allocation changes to deal with increased risk and uncertainty. During these periods, it can become increasingly difficult for traders to make decisions. Excessive volatility can negatively impact the broader economy and indicate a market downturn—it can make things difficult for retirees relying on steady income from their portfolios to fund their retirement.
When volatility spikes, it can have multiple adverse effects, but there are opportunities for growth and getting ahead when things aren’t looking that great. For instance, traders can take advantage of price dips by buying up stocks at a cheaper price and then eventually selling them off when prices increase once more.
Straddles and Strangles
When volatility increases, advanced and professional traders usually see these as opportunities to profit from trading strategies like straddles and strangles—these can be especially beneficial during an election cycle.
A straddle is a neutral options trading technique in which traders buy a put and a call option for the underlying security with the same strike price and expiration. The goal of a straddle is to profit from a big price move in either direction. They’re best used when a price move or short-term volatility is expected ahead of market events, such as the release of an earnings report. The potential profit is unlimited on the upside, and the possible loss is limited to the total cost of the straddle plus commissions.
Iron Condors for Stability
Using an iron condor strategy, options traders can bet on the relative stability of an underlying asset by buying two call options and two put options. Combining these two pairs of options allows the investor or trader to profit if the underlying asset’s price remains stable. This is the ultimate trading technique for traders who want to limit risk while taking advantage of volatile markets. The benefit lies in the trader generating a larger premium while severely limiting a potential loss. Traders can effectively limit possible risk but don’t need an underlying to move anywhere.
Hedging Your Portfolio
Traders may use options to hedge existing stock positions during an uncertain election season. To hedge a long stock position, traders could buy a put option or place a collar on the stock. Buying the put would lock in a price temporarily below the stock’s current price, and then the trader could sell the stock.
Timing Your Trades—Pre- vs. Post-Election Strategies
Like with any other kind of trading, it’s key to time everything right to maximize potential profits and minimize potential losses. This involves using pre-election and post-election strategies, which we’ll discuss in more detail in the next section of the guide.
Pre-Election Volatility
Options traders need to position themselves before the election to meet their trading goals and not let emotional trading break their focus. Know that election coverage is mainly negative and that there will be increased volatility leading up to Election Day. To capitalize on these uncertainties and potential price swings, traders should look for opportunities to trade in these ideal conditions through long puts, short straddles/strangles, iron condors, or short calls.
Post-Election Market Reactions
Following the announcement of the election results, options markets typically go through rapid price adjustments, which presents potential opportunities for traders:
- Scalping: This non-directional trading strategy involves taking advantage of small price changes that might not reflect the overall market trend. It can be used when markets are moving up or down.
- Gap Fills: These short-live price movements occur when gaps occur due to sudden changes in market sentiment. Traders use these price movements to their advantage and fill the gaps, hence the name.
- Grid Trading: In this move, traders create a grid of orders to capture price movement in either direction. It involves placing buy and sell orders around a central price at predetermined intervals.
- Buying the Breakout: When a stock breaks out of its support or resistance range, the trader buys it up, which can lead to a substantial price increase if the breakout occurs in a volatile market.
- News-Based Trading: This strategy is perfect for trading after announcing who won the election. It takes advantage of the increased volatility surrounding the news event.
Case Study of a Recent Election
Let’s look at a real-world example of how the market responded post-election in 2020 following the victory of Joe Biden over Donald Trump. Generally speaking, the market following a presidential election is favorable to options trading strategies like put spreads, call spreads, and non-directional trading approaches like straddles and strangles. 2020 was no exception.
Following Election Night, there was an uptick in market volatility, though many of the uncertainties of the year were clearing up at that point. The idea of a potential Republican Senate majority signaled to many investors and traders that many of Trump’s pro-business policies and tax code would stay intact, despite the Biden victory. Many people were seeing America as moving back to the center. COVID-19 was still in full swing, but the introduction of drugs, vaccines, and other cures was putting those concerns to bed as well. Equities strategists at J.P. Morgan Research were expecting the S&P 500 to surpass its target of 3,600 by year’s end and reach 4,000-4,500 by the beginning of 2021.
With this environment in mind, traders and investors were able to use this market volatility to their advantage by using strategies like straddles and strangles where they could hedge against unexpected market movements while still profiting from any potential price swings the market threw their way. Traders also benefited greatly from rotating investments into sectors expected to benefit from the winning party’s agenda. In this case, it was green energy stocks and bonds.
The Role of Media and Polls in Market Sentiment
The mainstream media and pollsters can influence market sentiment as they cover the presidential election. Let’s examine how the polls, media coverage, and debates can negatively or positively affect the options trading market.
Impact of Polls and Media on Market Sentiment
Polls
Polls can be a helpful indicator of trends, how the electors are feeling about each candidate, but they can be misleading due to pollster bias, the lack of raw data that comes with early voting or mail-ins, and the fact that it’s people that vote and not the polls. In many cases, polls and aggregates are used to inform betting odds, which can ultimately drive market sentiment based on the likelihood of who will win the election.
Media Coverage
The media can be helpful in informing viewers about polling information, covering debates, and conducting town halls of likely voters to gauge public sentiment. However, there are problems with media bias, where political pundits clearly take sides and try to shed the worst possible light on the opposition.
So long as the media can cover the facts objectively, markets remain relatively even keel. However, the truth is that the media can mislead the public’s perception of what might really be going on in the election cycle. This can lead to traders or investors becoming uncertain, which opens the door to market volatility.
Debates
These events are great opportunities for both candidates to showcase their leadership plans and what they offer the people as the next hopeful president. Following the event, investors can get a clearer picture of each candidate and either feel confident or not confident about who is likely to win the election and how that will affect the market in important sections like defense, financials, or energy.
Short-Term vs. Long-Term Sentiment
Distinguishing between short-term emotional reactions to media reports and long-term market adjustments based on actual election results can be your greatest weapon. It’s best not to make knee-jerk decisions about the news but to see how things play out and do additional research to pinpoint long-term trends you should be concerned about. Don’t get caught up in short-term sentiment.
The Trader’s Advantage
The trader’s primary advantage is the power to stick with their trading plan and not let news from the pollsters or the media rattle them into making foolhardy trading decisions. We’ve included some helpful tips on how traders can avoid reacting emotionally and instead make data-driven decisions:
- Be willing to let go of losing positions, even if you’re tempted to see if they’ll turn around.
- Trading with discipline isn’t the same as trading in fear. Don’t get off track with your trading plan because you feel you’re being too cautious.
- Follow your trading plan during your current session and make changes following evaluation, journaling, etc.
- Don’t trade when you’re angry, frustrated, fearful, overconfident, or greedy. Take a break when emotions begin setting in.
- Follow each trade with a break for good measure.
- Track profit and loss, but do it afterward when evaluating your session. To save time and thought, use automated take-profit or stop-loss systems.
Risk Management During Election Cycles
The risk management technique for options trades during the election cycle is similar to that for options trades at any other time of the year. The key is to have a plan with limits for profit and loss and a system for how much capital goes to each position.
Avoiding Emotional Trading
Remember the importance of sticking to a well-researched strategy you’ve designed for your overall trading plan. It’s best not to get caught up in emotion trading, where you allow your decision to be dictated by fear or excitement. Stick with your plan and make sound adjustments to your strategy if they’re appropriate. Don’t let uncertainty get a foothold in your trading plan—avoid emotional trading decisions!
Risk Mitigation Tactics
As with any other trade you perform when it isn’t an election cycle, managing risk by diversifying your portfolio in various asset classes and industries or setting stop-losses to cut down on potential losses is critical. Setting up proper stop losses also means generating a unit for how much capital you allocate to each trade (1-2% is best).
Conservative vs. Aggressive Strategies
Risk tolerance is how much you’re willing to risk on a single trade. The best way to make money trading but retain as much capital as possible is to use only 1-2% of your capital on each trade. It’s also best to take at least 20-25% in profit before selling. This is the conservative approach.
Consider a more aggressive approach if you have a higher tolerance for risk than his down-to-earth strategy. For example, you might dedicate 3-4% of your capital to each position and stay longer in the trade to maximize profit. A lot of it comes down to risk tolerance, your experience level, and how much capital you have on hand.
Stick With Your Trading Plan During Presidential Elections
Understanding how presidential elections can influence options markets and the need for adaptable strategies is essential. The best way to trade around election cycles is to have a plan going into Election Night and following the winner’s announcement. Expect volatility to increase going into the night, and have a few trading strategies to capitalize on these conditions. Then expect big price adjustments in the market after the winner is declared, so have some options trading techniques to leverage price movements in either direction to your advantage as well!
Stay informed, monitor market conditions, and have a solid risk management plan during election cycles. You can find more helpful articles and information at OptionsTrading.org.
