Brexit 2.0? Quantifying the Overnight Election Risk to Bulls

With the Brexit shock fresh in Wall Street's memory, investors are feeling high anxiety ahead of the November 8 presidential election

Senior Vice President of Research
Nov 7, 2016 at 8:46 AM
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"... since a Friday sell-off on Sept. 9, the SPDR S&P 500 ETF Trust (SPY - 212.54) has now closed between $212 and $217 in 34 of 35 trading days.

"... a couple of technical patterns on a daily chart are indicating the potential for a breakout from the $212-$217 range could be on the horizon, although these patterns are in conflict in terms of the direction of the breakout...  a bearish 'descending triangle' is emerging. A close below the $212 level would heighten the chances for a move to the $205 area in the short term... [but] there is strong potential support in the round $210 area. In fact, if support did emerge in this area, a bullish 'falling wedge' pattern would be in play... The base of this wedge is currently just above the round 210 strike."

-- Monday Morning Outlook, October 31, 2016

"Macroeconomic Advisers, a St. Louis–based forecasting firm, predicted that the Standard & Poor's 500 index would fall 7% if Trump wins, a prediction derived from how stocks have moved on a daily basis in recent months as Trump's odds of victory changed."
-- Barron's, October 29, 2016

"The Nov. 8 presidential election between Hillary Clinton and Donald Trump has trading firms preparing for potential upheaval -- financial, political and personal. They're boosting staffing, carrying out stress tests and hedging bets in the event of Brexit-style turbulence on Tuesday... From currencies to bonds to equities, volatility is surging. The measure of stock-market fluctuations, known as the VIX, climbed for eight-straight days through Thursday, matching the longest streak on record."
-- Bloomberg, November 3, 2016

Perhaps with Halloween just passing, it was appropriate that "scared" traders and investors took center stage last week with the 2016 presidential election imminent. Selling and hedging activity predominated as various polls revealed that Donald Trump was narrowing the gap on Hillary Clinton. As a result, the SPDR S&P 500 ETF Trust (SPY - 208.55) finally moved out of a seven-week trading range, breaking below potential support in the $210 area. In fact, a new streak occurred -- nine consecutive losing days.

As we said last week, this technical breakdown increases the possibility of a move to the 205 strike in the short term, the target for a bearish "descending triangle" formation that we discussed. This pattern becomes "broken" if the SPY manages to move back above the base of this triangle at $212.

Friday's action may have given the bulls a little bit of hope that the bear pattern is a false breakdown, as the lows occurred just above the 208 level, site of: 1) its 200-day moving average; 2) the vicinity of its year-over-year breakeven level; and 3) the largest put open interest strike in the weekly Nov. 4 option series that expired on Friday. That said, the sell-off in the last hour of the day may have dampened some hopes.

spy daily with 200 day moving average

The behavior of the CBOE Volatility Index (VIX - 22.51) in the past couple of weeks is much like that of June, when it began rising ahead of the late-month Brexit referendum. In fact, on Thursday, Nov. 3 -- for only the fourth time since 2010 -- the VIX reading was three times greater than the S&P 500 Index (SPX - 2,085.18) actual volatility. In other words, while the market has not displayed a lot of pre-election volatility, expectations for post-election volatility have soared.

One noticeable difference, however, is that VIX futures call buyers were nowhere to be found in the options market ahead of the Brexit referendum, as is evidenced by the fact that the 10-day, buy-to-open call/put volume ratio was at multi-month lows, and only began rising when the Brexit "surprise" occurred. Said another way, VIX option speculators were caught flat-footed prior to a massive spike in volatility in June.

This time around, VIX buy-to-open call/put volume ratio has soared, as speculators and hedgers gravitate toward the purchase of VIX futures calls relative to puts. After all, with Brexit fresh on the minds of traders and investors, VIX option players are more open to a negative surprise -- and a corresponding volatility spike -- if the election outcome is perceived as a negative. The behavior of the VIX call/put volume ratio offers an excellent illustration of the caution that exists pre-election relative to pre-Brexit.

vix call buying

Also of note are the heavy put purchases on SPY options relative to calls, as the 10-day, buy-to-open put/call volume ratio spiked to 2.42 late last week -- its highest reading in 15 months. For perspective, this reading was only 1.46 immediately ahead of the Brexit referendum. SPY put options can be used to hedge equity portfolios or bet on a broad-market decline. Whether the put activity is hedging, speculative, or a combination of both is irrelevant. The takeaway is that it appears traders and investors are expressing considerably more caution ahead of the presidential election than the Brexit referendum.

spy put buying ratio

For what it's worth, the biggest 10-day open interest change for SPY options expiring through the Nov. 18 standard expiration has been at the 200 put strike, followed by the 208 and then 205 put strikes.

spy 10 day open interest changes

With the Nov. 8 presidential election occurring within the two-week window ahead of standard options expiration on Nov. 18, it is worthwhile to observe the current SPY open interest configuration for all options expiring through standard November expiration.

Standard option expirations usually carry more open interest than weekly expirations, and therefore the influence of options open interest can have a higher impact on index and exchange-traded fund (ETF) action. Said another way, the bigger the put open interest, the bigger the potential "magnet" effect during sell-offs. However, the bigger the put open interest, the greater the number of short positions associated with the put open interest that will be unwound as expiration nears. The unwinding of these short positions would have a net positive impact, as long as the SPY remains above the heavy put strikes as expiration(s) near.

With that said, note the current open interest configuration for the SPY, as shown on the graph below. With the move below the 212 strike last week, the SPY is vulnerable to moving lower through heavy put strikes down to 205 (the target for the bearish triangle pattern) -- or even 200, site of more than 380,000 put contracts for all SPY options expiring through Nov. 18, in addition to the post-Brexit low.

The 205 strike would be the first line of defense, since put open interest at this strike is much more significant relative to the strikes immediately below it, which might be considered smaller magnets. But if momentum sellers were to join the party, the 200 strike would become relevant.

The takeaway here is that a perceived negative election outcome could cause the SPY to gap down to either the 205 or 200 strike. This could be viewed as a long's overnight risk after the election. If such a scenario were to occur, to the degree an overnight gap of this size is related to the heavy put magnets, the sell-off would be short-lived. In fact, the lows would likely occur in the pre-market hours, before the 9:30 a.m. New York time open.

spy open interest by strike

Finally, options are a great way to play the uncertainty of the election. The combination of less money at risk and the leverage to play an unknown (and potentially large) market move is appealing. Against this kind of backdrop, buying options gives you the greatest profit potential. And your risk is limited to your dollar outlay. With that said, given the caution ahead of the election, SPY calls are currently much cheaper than SPY puts.

For example, at the close on Friday, a weekly 11/11 expiry, 5-point out-of-the-money call (a bet on a post-election rally) was asked at $0.87. However, an 11/11 5-point out-of-the-money put was asked at $1.80. In other words, calls are cheap relative to puts -- and it is a contrarian bet that just as market participants were wrong by not being cautious ahead of Brexit, they'll again be wrong by being too cautious ahead of the election.

Or, given that volatility has soared already pre-election, and volatility call buyers emerged in recent days (unlike pre-Brexit), another contrarian bet would involve positioning for a volatility crush this coming week, or in the weeks ahead. The bet would be that just as VIX futures option speculators were caught flat-footed in the days before and immediately following Brexit, they're on the wrong side of the trade again by positioning for a huge post-election volatility surge.

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