Smart Investor: Preparing for election-driven market volatility: hedging strategies to consider

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Preparing for election-driven market volatility: hedging strategies to consider

Introduction

It’s D-Day for the U.S. markets—election week is here, and the stakes are high. As voters head to the polls, investors are bracing for possible turbulence, with the put/call ratio recently spiking to 1.61, the highest level since August 5, 2024. Back then, a surge in volatility shook the markets following a dramatic JPY carry-trade unwind, and this elevated put/call ratio suggests that investors are once again turning cautious.

In simple terms, more market participants are trading puts than calls, indicating a rise in hedging activity as they seek to insure their portfolios against potential downside. With key sectors like technology, healthcare, energy, and defense highly sensitive to policy outcomes, hedging strategies—such as buying SPX puts and sector-specific options—can provide a valuable buffer against election-driven market reactions.

For more insights into stocks that may be particularly sensitive to election outcomes, see the recent analysis from my colleagues here.

Why election outcomes shake the market

U.S. elections often introduce volatility as policies affecting taxes, regulation, and spending shift with new administrations. Traders adjust positions based on anticipated policy changes, which can create price swings across the market. While predicting the election outcome or its market impact is challenging, hedging can help investors protect their portfolios.

Important note: the strategies and examples provided in this article are purely for educational purposes. They are intended to assist in shaping your thought process and should not be replicated or implemented without careful consideration. Every investor or trader must conduct their own due diligence and take into account their unique financial situation, risk tolerance, and investment objectives before making any decisions. Remember, investing in the stock market carries risk, and it's crucial to make informed decisions.

Hedging the market with SPX puts

A simple method for broad protection is buying put options on the S&P 500 index (SPX), which appreciate in value if the index declines. SPX puts can capture immediate volatility or offer longer-term protection depending on the chosen expiration date. Slightly out-of-the-money puts (e.g., 2-5% below the SPX level) often strike a balance between cost and potential downside coverage.

Sector-specific hedging: targeting vulnerable areas

Some sectors are more exposed to election-driven policy changes than others. By focusing on these, investors can target the specific areas of their portfolio that may be most affected:

• Technology: Big tech may face regulatory scrutiny around data privacy and antitrust. Stocks like Amazon, Google, and Facebook are at heightened risk.
• Healthcare: Drug pricing and Medicare policy changes could impact insurers and pharmaceutical companies. Stocks like UnitedHealth Group and Pfizer are good candidates for sector-specific hedges.
• Energy: With energy policy at the forefront, renewable energy and oil companies face distinct election-related risks. Enphase Energy and NextEra Energy might benefit from pro-renewable stances, while traditional oil companies like ExxonMobil could face headwinds if policies favor stricter environmental regulations.
• Defense: Shifts in military spending or foreign policy could impact defense contractors. A hedge on major defense stocks may be prudent if spending priorities shift.

Using puts on these sector-specific stocks can be effective, though they may be more costly due to higher implied volatility in sensitive sectors.

Cost-effective alternatives: spread and collar strategies

Protective puts can be pricey, particularly with elevated volatility. Spread strategies, like put spreads, help manage these costs while still offering meaningful protection. Let’s look at an example:

In this example, we see a put debit spread on the SPX. It involves buying a 5300 strike put and selling a 4500 strike put, both expiring on November 15, 2024. This setup costs a net debit of $9.50 (or $950), making it an affordable election hedge.

A major benefit of this spread is its exposure to implied volatility (IV). The spread’s net vega of 1.0372 means it can gain value if volatility rises. For instance, a 30% IV increase would add about $30 to each option’s value, significantly boosting the spread's worth—even if the SPX price remains unchanged. This makes the spread an efficient way to gain from volatility spikes without needing an immediate price move.

For those with large stock positions, collar strategies are another option. By buying a put and selling a call, a collar can protect downside with lower net cost, though it caps upside.

Sector ETFs: a middle ground for broader, targeted exposure

Sector ETFs offer a way to hedge without targeting individual stocks. By purchasing puts on ETFs, investors can protect entire sectors from policy shifts. Here are some key ETFs to consider:

• Technology: XLK (Technology Select Sector SPDR Fund) provides broad exposure to tech stocks.
• Energy: XLE (Energy Select Sector SPDR Fund) covers renewable and traditional energy companies.
• Healthcare: XLV (Health Care Select Sector SPDR Fund) includes a range of healthcare companies, useful for managing healthcare policy risks.
• Defense: ITA (iShares U.S. Aerospace & Defense ETF) focuses on defense and aerospace companies.

When trading options on these ETFs, it’s common to use U.S.-listed versions (e.g., XLK, XLE) rather than UCITS-compliant European versions. UCITS ETFs generally lack the liquidity needed for options trading, which can make it harder to execute trades effectively. Since we’re only trading the options, the U.S.-listed versions provide the necessary liquidity for smooth transactions.

For further insights into how the election outcome might impact sectors across the market, see the latest election-focused analysis here.

Adjusting your hedge after election day

Market reactions to the election are rarely confined to a single day. Monitoring post-election sentiment and adjusting hedges accordingly is important. If the market stabilizes or election results clarify, consider closing profitable hedges or rolling positions to match the new environment. For prolonged volatility, extending hedge expiration dates may offer continued protection.

Conclusion: strategic hedging as a defense against the unknown

Election season hedging isn’t about predicting the future; it’s about protecting portfolios from potential surprises. With a balanced approach, such as SPX puts for broad coverage and sector-specific hedges for targeted exposure, investors can manage risk without disrupting core holdings. As election results unfold, stay informed and adjust as needed, using hedging as a safeguard against the unpredictable.