November 6th, 2012
Stock options are bets, pure and simple. A trader can place a bet that a stock price will go up by buying a call option, or bet that it will go down by buying a put option. It is also possible to place a bet that the price will either go up or down by buying both a call and a put. To the inexperienced trader, a monumentous event such as a presidential election may seem like a golden opportunity for an option trade. However, such a trade could be a potentially very costly mistake.
Options Are Not Lottery Tickets
Although options somewhat resemble lottery tickets, there is a major difference. Understanding the difference can save a trader from frustration, and help avoid unnecessary losses.
Lottery tickets have a fixed price. A ticket costs $1 whether the jackpot is $1 million or $100 million. Obviously a ticket for the larger jackpot represents a better "bargain". We have all seen TV footage of the long lines outside businesses that sell lottery tickets when the jackpot has reached an obscene level.
Options do not have a fixed price. Events that have the potential to generate a jackpot for option holders cause an increase in price, because the premium of every option is based on the potential amount of any jackpot.
Stock Prices Have an Expected Range
Stock prices rarely remain stationary; they move up and down within a range of prices during a period of time. Take the Dow Jones for example; during an average week it may sometimes be expected to trade up or down as much as 150 points. Of course it will not always stay within the expected range, but there is always an expectation among traders as to what that range will be.
A popular TV game show gives a perfect example of how a trader might view the market. If the Dow was trading at 13,200 and the expected weekly range was 150 points, one might expect it to be either 75 points higher or 75 points lower after a week had gone by. The expected range would be between 13,125 and 13,275.
A Tale of Two Traders
Every option trade involves two traders. In order to buy an option there must be someone willing to sell it, as can be seen in this example:
- Trader A wants to buy a call option because he believes the Dow will go up above the expected range. He is willing to pay a premium for the option, but not one that is so high that it will eat up all of his profits if indeed he is correct in his prediction,
- Trader B wants to sell a covered call because he believes the Dow will stay within the expected range. He is willing to accept a premium for the option, but not one that is so low that it will not cover his losses on the stock if the Dow declines towards the bottom of the range.
Both traders will eventually settle upon a price that each believes is fair. That price is always dependent on the expected range of the Dow.
Presidential Elections Increase the Expected Range
Nobody knows for sure who will win the presidential race. Even if the winner were known, the possible effects of a change in leadership in the House or Senate would need to be taken into account. There are many unknowns.
Because there is a very real possibility of significant changes in government policies after the election, there is also a very real possibility that those changes will affect the stock market. To put it bluntly, the range of expected stock prices has increased because nobody currently knows for sure what will happen after the election.
The end result of an increase in the expected range of stock prices is an increase in the premiums of stock options. If the expected range of the Dow increases to 300 points due to the uncertainty surrounding the election, call option buyers will be inclined to pay a higher premium in case the Dow rockets higher after the election. Covered call sellers will tend to demand higher premiums because of they don't know if the market will collapse after the election. The same process applies to put options and all other option combinations; all options will tend to have inflated premiums.
Post-Election Volatility Crush
The same process that inflated the premiums on stock options prior to an election will tend to decrease the premiums shortly after the election results are known. Quite simply, the expected range for most stocks is much higher before the election than it is after the winner is known.
The expected range of stock prices is often called "implied volatility". Implied volatility is generally much higher before a major event than it is after the event has passed. When the expected range of stock prices falls, implied volatility also falls. When implied volatility falls, option premiums tend to decrease. Occasionally, option premiums decrease so much it is as if they were crushed. When option premiums decrease significantly after an event such as a presidential election, it if often called "volatility crush".
Avoiding Volatility Crush
The easiest way to avoid a collapse in volatility after a presidential election is to simply not trade any options in the days before the results are known. It is very tempting, especially for a new trader, to think that it is possible to outsmart the options market. The possibility of winning a big jackpot when the election causes a huge move in one direction or the other may make it appear as though buying both a call and a put option is a no-loose trade. Such temptations are best avoided in most circumstances.
Very often that seemingly big jackpot disappears under the effects of Volatility Crush. It is quite possible to lose money on a call option when the Dow is up 100 or more points after an election, and just as possible to lose money on a put when the Dow has a triple digit loss. If both a call and put option are purchased, as in a long straddle, the Dow can make even bigger moves and still result in a loss for the holder of those options.
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About the Author
Christopher Ebert uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. He studies options daily, trades options almost exclusively, and enjoys sharing his experiences. He recently co-published the book "Show Me Your Options!"