A Simple Market Trade to Play Volatile Midterm Elections

0 | By Shah Gilani

Considering how volatile the stock market’s been lately, odds are that whatever the outcome of today’s midterm elections will be, the market’s likely to react strongly.

Three possible political outcomes could arise from today’s midterm elections.

  • When heavily jaded and weighted emotions are sidestepped, the consensus is that Democrats will win control of the House of Representatives and Republicans will retain control of the Senate;
  • Next, there’s an even bet out there that the Republicans will retain control of both Houses;
  • Then, based on Democrats more vocal proponents, there’s a better-than-even bet that Democrats will end up winning a majority in both the House and Senate.

And those three possible outcomes could yield three different market reactions.

If the Democrats win a majority in the House and Republicans retain control of the Senate, history tells us a divided government, resulting in frustrating political gridlock, is good for the stock market.

According to Barron’s calculations by John Lynch (Chief Investment Strategist at LPL Financial) and Jeffery Buchbinder (LPL’s Equity Strategist), “The combination of a Republican president and a split Congress resulted in an average annual return of 15.7% for the S&P 500 since 1950.”

Lynch and Buchbinder also said that a “Democratic president and a GOP Congress produced an 18.3% annual return.” Which Randall Forsyth of Barron’s says, “supports the conventional wisdom that Wall Street likes gridlock.”

But, that’s longer term. Those positive numbers are annualized returns.

Given how volatile the market’s been for the past month, day-to-day and even more so intraday, it’s highly likely that in the short-run – in the days after election results are tallied – the market will swing hard one way or the other, or swing up and down wildly trying to get some footing.

But no matter the outcome, here’s a simple, cheap way to play the market no matter which way it goes…

Markets Always Fall Faster Than They Rise

The set-up for my expectation for short-term volatility is twofold.

First, it’s impossible to not “feel” the intensity of emotions surrounding this midterm election.

And, while feelings don’t seem to be prime movers of stocks, especially over short-run periods, they absolutely can be.

I always say, capital moves markets, but psychology moves capital.

The strongest market movers, in terms of feelings and psychology, are fear and greed. Analytics and metrics aside, because even the same metrics can be viewed differently by different analysts, when emotions run high, as they are this election period, the market’s likely to react based on amped up emotions of investors reading what the election outcome will mean for stocks, at least in the short run.

One argument – that stocks will crash if the Democrats win both Houses, based on the belief that there’ll be a huge pushback on President Trump’s agenda, including possibly a rollback of corporate tax cuts – is knocked by Democrat pundits who say, if the market is a discounting machine and the consensus is that Democrats will do very well this election, then why hasn’t the market already tanked?

Well, it kind of has. The market’s sold off, sometimes scarily so, since the beginning of October.

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If the selloff we’ve seen is a precursor to investors exiting if Democrats do well today, it may be a worthwhile bet to suppose the market will see more downside action if Democrats win a majority in both Houses – maybe a very big downside move.

If that’s a worthwhile bet, it makes equal sense to bet that the market could jump higher, as in stage a relief rally followed by sidelined investors buying back in, if Republicans hold both Houses.

I like playing the prospect of a big market move, one way or another, at least as a short-term knee-jerk reaction to a lopsided outcome.

We’re playing both possibilities in my elite research service, The Money Zone.

We bought call options on the S&P 500, to make money if the market jumps higher. And we bought put options on the S&P 500, to make money if the market tanks in the short run.

As a proxy for the actual S&P 500, we bought calls and puts on the SPDR S&P 500 ETF (NYSEArca:SPY).

With SPY closing at $271 on Friday, we bought calls yesterday with a strike price of $286.50 that expire on November 16, 2018. We paid $0.12 for them. And we bought puts with a strike price of $236 that expire on November 14, 2018. We paid $0.05 for those.

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Owning the $286.50 calls, which are 15 points, or almost 6% higher than where SPY closed on Friday, seems like a big jump for the market to make, especially since we only have 10 calendar days to get up there for those calls to be at the money.

But, we won’t need that big of a move in SPY for our cheap calls to make money. If the market jumps higher, our calls should spike in price. If they go from $0.12 to $0.24, that’s a 100% gain. An emotional reaction to the election makes that possibility a worthwhile bet for us.

We have even less time with our $236 strike puts, which are 35 points out-of-the-money, or almost 13% below where SPY closed on Friday, because they expire in eight days.

But, here again, if emotions are high and investors react negatively to the election outcome, the downtrend we’ve seen since October could accelerate quickly.

Markets always fall faster than they rise.

It won’t take much for our puts to double in price, if stocks tank.

To see more about these kinds of “modified straddles,” just click here for more information. I’ll walk you through exactly what we do at The Money Zone, and, if you act quick, you might have the opportunity to jump on this trade recommendation, too.

In fact, the last 13 recommendations we closed out (including partial closeouts) have been winners. Here’s just a taste:

  • 53.85% on the first half of VIAB calls and 153.85% on the second half
  • 95.00% on the first half of HAL puts and 120.00% on the second half
  • 110.59% on the first half of SPXL puts and 52.94% on  the second half

In the meantime, we’ll hope our politicians do the right thing for us in the long-term.



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