Here in the U.S., it is election season. That time every two years where the focus turns to what could happen when the electorate goes to the polls in November. Of course, this year it is even more meaningful because this is a Presidential election cycle, happening every four years, in which there is a lot more media, national conventions and speeches galore. Investors are left to wonder what, if any, policies will impact markets on a forward-looking basis.

I learned in my career that, as a trader, it is best to be apolitical. It does not and should not matter who one wants to win the election, what matters is what the market is pricing in relative to the outcomes we get. Traders can’t let emotions impact their trading strategy.

I watched with interest the price action around the Republican National Convention from July 15-19. As you can see from the rectangle on the chart above, this coincided with the top of the market. Of course, I can also see from the RSI in the lower panel, the market was very overbought at this time. It was also a week with some interesting economic data, but not necessarily the type that moves markets materially (Empire Manufacturing, Philly Fed, Housing Starts, Retail Sales). Technically, the market was overbought, but was it the convention that was the catalyst to the fall?

At the RNC, Donald Trump was named the nominee from the Republican Party. He also named his running mate – Senator J.D. Vance of Ohio. An assassination attempt on Donald Trump caused chaos on July 13, two days before the convention. A debate was held between Donald Trump and Joseph Biden on June 27 that led to calls, from the Democrats themselves, for Biden to step aside as the Democratic nominee. Lots of moving parts – but as illustrated in the graph above, the white line shows market sentiments regarding the odds of Donald Trump becoming President. These odds rose to a peak on the first day of the convention, July 15. That led to a fall for the next several weeks.

If I look back to the start of the year and plot these odds vs. the 1-month implied volatility of the SPX, I can see that whenever the odds of a Trump presidency went up, implied volatility went lower. Conversely, whenever the odds of a Trump presidency fell, implied volatility rose. I acknowledge there are other moving parts here – economic data, earnings data, changing Fed policy. However, there is a link as well between these two series.

Trying to stay apolitical, is this a tradable relationship? I see that Trump got a spike in odds on the first day of the convention. Could Kamala Harris see a similar spike in odds on day one of the Democratic Convention August 19? This means the Trump odds would fall; will that cause a move higher in implied volatility?

Of course, there has been other news this year, and not just election news. The biggest news has been the changing fortune of the economic data, and therefore, the changing stance of the FOMC. At the start of the year, there were over six rate cuts priced into the Fed Funds futures market for 2024. At one point in June, there was only one rate cut left.

After some more economic data, as well as a more dovish stance in the last FOMC meeting, the market is beginning to coalesce behind the idea that the FOMC will begin its rate cut cycle in September.

One can see from FedWatch, a tool from CME Group, that the market sees more than one rate cut in September, with 51.5% odds of 25 basis point cut. and 48.5% odds of 50 bps cut as of the first week of August. This is important not so much because of the rate-cutting cycle, as this will be offset by the changing economic growth views – worse data means more cuts, better data means fewer cuts. It may be important because the primary variable on which the market focuses will no longer include the FOMC and data, but the divergent possible policies of the two candidates in November.

If starting to consider a possible trade around the Democratic National Convention, which runs from August 19-22 in Chicago, it may be best to look at the term structure of implied volatility to get a sense of what is priced in.

As I look at the front part of the curve, I can see a very wavy pattern developing. Not only may there be catalysts at some of these nodes, but with daily options, I see the traders adjust their implied volatility to consider some options to have more ‘dead’ time decay than others.

For example, all else equal, one would rather buy options expiring on a Friday than a Monday. For a Monday option, two of the last days before expiration, the market is closed. Yes, we can certainly gap higher or lower over a weekend, but the typical adjustment is to consider weekend days only ‘partial’ days and adjust price lower, which in turn means that Monday implied volatility tends to be lower than the other days of the week. If I look at the E4AQ4 Monday, August 26 options, however, they may actually be appealing, because this is the Monday after the conclusion of the DNC.

One can expect many speeches on the campaign trail by both candidates as well as a great deal of international media attention. That weekend in particular, one might expect to see the Republican response to whatever policy was mentioned at the DNC. This is the typical playbook. These Monday options could potentially embed more volatility than a ‘normal’ Monday option, yet the implied volatility is priced relatively lower. How can I see what volatility is priced in for this Democratic Convention catalyst?

A trader can turn to the CME Group Event Volatility Calculator to see what implied volatility is embedded in the market for the particular event of the convention. I put the closing date of the convention in the calculator, and using options that expire before and after this date, the calculator computes what implied volatility is being used for that particular catalyst. You can see the answer in the upper rate corner, as a 14.98% volatility or lower, actually, than all of the volatility around it.

One may interpret this as saying this particular catalyst is a volatility dampening event. That to me is potentially interesting, as if a trader expects to see a spike in the odds of a Harris Presidency, which is not a stretch since this happens for most candidates around their convention. Because I know that lower Trump odds has meant higher volatility, not lower volatility, it appears to me there could be a trade here. 

Before I choose to express any views in options, I want to see how the market may be positioned. One reason that it could be a volatility dampening event is if it’s fully expected, and it becomes a ‘buy the rumor/sell the news’ type of event. I focus on the levered money positioning particularly because of the de-risking/de-leveraging episode that the markets have just gone through in August. As you can see in the chart above, the net positions for levered accounts are at the highest levels seen over the last two years.

In fact, whenever markets have hit this level of net positioning, there have typically been net selling of futures from levered accounts. The initial selling from the peak – January 2023, October 2023, May 2024 – has led to weakness in futures. While the market has recovered and gone even higher each time, there seem to be the possibility of two-way moves as markets move away from the peak of positioning.

Combining these views, I come away with more of a sense that we could see movement in the underlying futures, even if the direction is not entirely clear. In the generic futures chart, I see that numbers have come off of oversold levels but have broken below short- and medium-term moving averages. This might suggest more selling of rallies than buying of dips.

If futures positioning does come off the recent highs, this has tended to initially lead to lower futures prices before a subsequent rally, then higher. If Harris were to get a spike in odds, which lowers Trump’s odds, that has served to lead to higher implied volatility, at least so far in 2024.

Finally, the Event Volatility Calculator suggests the forward volatility for the DNC event is actually lower than all of the days around it. This all points to me looking to buy the Monday, August 26 straddle at 142 ticks. I am effectively buying the DNC event for a sub-15% volatility. Not only that, but I gain exposure to any volatility that comes from any other catalysts that could happen in the next 10 days.

A trader can let this play out in one of two ways. First, they could look at this as a breakeven trade, thinking that higher volatility, regardless of direction, could lead to a move outside the breakeven of the straddle. At the price one pays, the breakeven for the 5375 straddles are 5232 and 5517, as identified on the chart above.

Second, a trader can also look to dynamically hedge their straddle position and focus on higher levels of historical or realized volatility even if markets do not move beyond the breakeven levels. The idea here is to re-hedge deltas every 0.5 or 1 standard deviation, in an attempt to make more money trading deltas than one is losing in time decay or theta. At a 14.98 implied volatility, the straddle is pricing in 0.944% move every day until expiration (14.98/15.87 - the square root of 252 trading days). If the futures have a high/low range of more than 0.944%, the trader will make back their theta. If the move is less, they will lose.

In closing, the trader could express a directional view, long or short, as well. That directional view was not as clear to me but the more important point, in my opinion, is that the Monday, August 26 expiring options are pricing in a forward volatility for the DNC that is lower than on all the days surrounding it. Thus, long options would be a great way to express a directional view, too. Of course, buying options carries the risk of the loss of premium, though it is a defined risk way to express a view.

CME Group provides many tools for traders to interpret the pricing in the market to find the best expression of their views.

Good luck trading!

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