If the U.S. Election Is Anything Like Brexit, Volatility Is Too Cheap Right Now

Complacency hasn't slipped in the polls.

If It's an Election Year, Expect Market Volatility

Analysts can't agree on whether, if Republican nominee Donald Trump emerges victorious in November, he'll usher in a global recession or cause the American economy to "take off in a big way."

But somehow, those with the most money at stake don't seem too worried about how U.S. stocks will react to a Trump presidency.

Just how sanguine are market participants?

According to Credit Suisse AG's equity derivatives strategy team, investors were more worried about a Federal Reserve interest-rate hike in September than they are right now about who will lead the world's largest economy for the next four years. That's even though markets never assigned more than a 50 percent probability to that long-deferred policy tweak taking place. 

CSuisse Election Vol
Source: Credit Suisse

"Despite the impending Nov. 8 election, equity [volatilities] are not pricing in much of an election risk premium, with S&P weekly options expiring Nov. 11 trading at just 0.9 vol point premium to Nov. 4 expiry — that’s less than what was priced in for the Fed meeting last week," writes Credit Suisse's team of the options on market volatility.

The notion of a Trump presidency would have seemed far-fetched just six weeks ago, when FiveThirtyEight.com pegged Clinton's odds of victory at close to 90 percent. But earlier this year, the world was taught to expect the unexpected when the U.K. cast ballots in favor of leaving the European Union, in defiance of pollsters.

Investors should look to employ the same playbook to protect themselves from the upcoming election, according to Pravit Chintawongvanich, head derivatives strategist at Macro Risk Advisors.

"The market had been pricing in a low volatility premium for the week of Brexit (June 24), but when polls showed the 'leave' camp taking the lead a week before the event, the market sold off and VIX spiked," he writes, referring to the CBOE Volatility Index. "Look at owning calendar spreads (selling the option that expires before the elections, to own the option that expires after the elections) – either as a way of cheapening up the option which captures the election, or as a bet that the market will price these higher as we near the election date."

Options markets imply the S&P 500 index is priced for a move of about 1.5 percent on the election outcome, the strategist added. That compares quite conservatively with the 3.6 percent drop in the benchmark index the session following the Brexit vote.

For many asset classes outside the U.K., the carnage in the aftermath of the referendum proved to be but a bump in the road. Less than a month after the vote, the S&P 500 index had marched to a fresh all-time high.

But as another seemingly major tail risk approaches, that's the wrong takeaway from Brexit, according to Morgan Stanley Chief Municipal Strategist Michael Zezas.

"In hindsight, watching the level of risk premium was key. 'Brexit' drove the biggest moves precisely at the points when it seemed the markets had moved to fully dismiss the event (two weeks before the vote, and right after the polls closed)," he wrote. "Second lesson, it pays to keep things simple. Selling the [British pound] worked; selling equities or credit did not.”

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