Analysis: Options traders get set for fiscal cliff, close vote

Sun Oct 7, 2012 4:42pm EDT

Traders await the Grupo Financiero Santander's first trade following it's IPO on the floor of the New York Stock Exchange, September 26, 2012. REUTERS/Brendan McDermid

Traders await the Grupo Financiero Santander's first trade following it's IPO on the floor of the New York Stock Exchange, September 26, 2012.

Credit: Reuters/Brendan McDermid

(Reuters) - Options traders in the U.S. stock market are getting their bets in place in case the U.S. economy tumbles down the "fiscal cliff," or worse, if the U.S. presidential election is so close that the result is disputed.

The stock market has been relatively calm in recent weeks in the face of uncertainty over the November 6 election and concerns that the economy could be pitched into a new recession because of substantial tax rises and government spending cuts - the so-called fiscal cliff - due to hit early next year unless Congress agrees to cancel or delay them.

Some option traders already are starting to build up protective positions on these big risks. In an environment of subdued volatility, the cost of doing so is relatively low, making it advantageous to take out insurance in case Washington remains gridlocked for an extended period after the election and the markets are roiled.

According to InTrade, current odds show President Barack Obama will be re-elected. However, expectations are Republicans should maintain control of at least the House of Representatives and possibly gain marginal control of the Senate.

Republican presidential candidate Mitt Romney's strong performance against Obama in the first of three debates last Wednesday night has improved his odds, though not yet enough to put him ahead in the polls.

The biggest shock would be if the election was so close that there was a legal battle over who won, mirroring the struggle between George W. Bush and Al Gore in 2000. That could further hurt the chances of compromise in Washington, and spook investors and the credit ratings agencies.

In the 2000 battle, Gore emerged as the winner of the popular vote but the results in Florida were disputed. Legal arguments dragged on for a month before Bush was declared the winner in Florida by 537 votes, thus giving him a margin in the Electoral College and the presidency.

During those weeks, the CBOE Volatility Index .VIX on an intraday basis crossed above 30 on more than one occasion, suggesting heightened anxiety. The widely watched gauge of investor anxiety ended at 14.33 on Friday, under its long-term average of 20.5 and well below the panic levels of 40 and higher seen last year during the worst of the euro zone crisis and after the U.S. lost its triple-A credit rating.

The S&P 500 .SPX fell about 5 percent to 1359.99 between election day and when the election result was finally resolved in mid-December.

Given the fiscal problems and weak economy, the impact of any disputed election would likely be greater this time around. The chances of a close call and subsequent legal disputes may have increased given there are already court battles over voter identification laws introduced in a series of states.

HIGHER-MAGNITUDE SHOCK

Futures contracts on the VIX fell Friday, though they show traders expect some additional volatility by year-end.

"We think the VIX will rise above 25 at some point over the next two months and possibly spike into a significantly higher-magnitude shock," said MKM Partners derivatives strategist Jim Strugger. A rising VIX, a 30-day risk forecast of stock market volatility, usually corresponds with a fall in stocks.

More telling is the rising bearish positioning in the S&P 500. As of Friday morning, open interest in November SPX put contracts was at 823,000 contracts, more than double the 384,720 outstanding SPX November call options contracts, according to options analytics firm Livevol in San Francisco.

Strugger recommends a number of strategies in single-stock positions as a hedge, such as puts, put spreads and collars, which involves an investor selling an out-of-the-money call to fund the purchase of an out-of-the-money put, for December and/or January positions.

Michael Schwartz, chief options strategist at Oppenheimer & Co, has set up an election protection strategy which involves buying inexpensive downside 1400 November puts on the S&P 500 Index to partially hedge a portfolio. The strategy limits downside risk while still allowing room for gains.

Regardless of who wins the presidency, the budget decisions facing lawmakers could make the end of the year a rollercoaster.

"The U.S. election may be a red herring, where the true issue may be the fiscal cliff after the election," said Steve Place, a founder of options analytics firm investingwithoptions.com in Mobile, Alabama.

Investors more worried about the fiscal cliff could use a put diagonal spread on the SPDR Dow Jones Industrial Average exchange-traded fund (DIA.P), Place said. Such a strategy gives the investor wider downside protection after November expiration, a bet that the election itself will be relatively calm, but the fiscal cliff will cause more volatility.

Place said a purchase of the DIA January 2013 $133 put strike and a sale of the DIA November $131 put strike would provide modest downside protection to about $125 into November, corresponding to about 12,500 on the Dow industrials .DJI. The Dow is currently at 13,610.15, which would roughly correspond to the DIA ETF at about $136; it closed at $135.96 Friday.

If the DIA is above $125 per share and below $133, which would require there to be a substantial correction in the Dow but not a crash, the investor stands to make between 30 and 100 percent on the position by November expiration. The January put leaves investors with more significant downside protection.

CALM CURRENTLY PREVAILS

With the S&P 500 at 1,460, up 16 percent on the year, volatility is low. Gareth Feighery, a founder of options education firm www.MarketTamer.com in Philadelphia, said conservative investors can exploit this calm to pick up relatively inexpensive puts as protection.

Puts, contracts granting the right to sell the underlying security at a fixed price by a certain date, can help investors insure their stock holdings against adverse price swings, while a call gives the buyer a chance to profit on a price rise.

With the risk of volatility spiking on whoever wins the election, the reward for purchasing at-the-money puts on the SPDR S&P 500 Trust (SPY.P) is attractive, Feighery said.

For example, the $146 SPY January strike put for a cost of $4.90 factors in a decline of about 3.3 percent by expiration. That would translate to a fall to about 1,413 for the S&P 500 Index .SPX .INX. The strategy will protect investors from any sharp pullback in the market by year-end.

Some traders are also suggesting playing key sectors based on the results of the election.

One example is the health care sector, which has been volatile during the Obama administration because of reforms to extend health insurance to tens of millions of Americans. Romney has vowed to repeal the Affordable Care Act, but his ability to do so may be constrained by Congress.

Health insurer Aetna Inc (AET.N) has already placed a $7.3 billion wager on the law not being repealed, said Brent Archer, options analyst at options research firm InvestorsObserver.com, in Charlottesville, Virginia. In August, Aetna agreed to pay a 20 percent premium for Coventry Health Care Inc CVH.N to expand its footprint in the U.S. government-backed Medicare and Medicaid programs.

For a bullish to neutral trade on Aetna, Archer likes the January 2013 $36-$38 bull-put credit spread for a 40-cent credit per share. That trade will make investors a 25 percent return as long as Aetna shares are above $38 at January expiration. They closed Friday at $41.66.

A bull-put credit spread is a strategy where an investor sells a put, then buys a lower-strike put - earning an initial credit. Ideally, both options expire worthless and the investor keeps the credit as profit on the trade.

No matter who wins the election, Mike Tosaw, a portfolio manager at Know Your Options, an advisory firm in Chicago, does not believe Congress will be able to cut spending enough to reduce the national deficit. That will hurt the value of the dollar, and makes precious metals a more attractive investment.

Tosaw views precious metals, particularly the SPDR Gold Trust (GLD.P) and the iShares Silver Trust (SLV.P), as long-term investments that have potential upside no matter the outcome of the election.

He said a collar is a good strategy to hedge against market volatility. For example, a holder of the SLV or GLD ETFs can sell a call that is about 10 percent out-of-the money and use the proceeds to purchase a protective put that is equally out-of-the-money.

"By doing that, you have 90 percent of your investment protected," Tosaw said. "The downside is that the upside is capped at about 10 percent profit."

(Reporting By Doris Frankel; Editing by David Gaffen, Martin Howell and Diane Craft)

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