The Low Probability Play

Friday’s action suggests that the market doesn’t particularly like the idea of a Trump presidency. That may or may not ultimately be true. There is also still a relatively low probability that we will even find out. But that doesn’t mean that we shouldn’t discount it entirely.

Trading, and options trading in particular, is a probability game. We need to look at the probability of something happening and then the impact if it does. Nassim Taleb is best known for writing The Black Swan, but his earlier book, Fooled by Randomness, is a book every option trader should read. In it (I am paraphrasing here) he tells the story of discussing his market outlook with a trading firm. When asked, he says that he is overall bullish, but when asked what trade he was going to place he said he was going to buy puts. The audience was rightfully confused, but he explained that while he thought there was a high probability that the market would go up some, there was a lower, but distinct, possibility that the market would drop by a large amount, making the put the best way to position.

Brexit was a great example of this. The polls said it wouldn’t happen and the markets were betting that was the case. But the possibility was there in that case, better than 40% and smart traders were able to place bets that paid off nicely when that lower probability, high impact event happened.

Now we face another event that could have a potentially large impact. If Trump wins, the market could tumble. That fear is what has driven the VIX up 50 % in the last seven trading days. And there is no saying that the market won’t sell off after the election regardless of the outcome. You just never know what might happen.

So how do we approach this market?

The first way to approach it is likely the least popular, but best for most people. Sit on the sidelines until after the election. Volatility is already getting priced in, making options expensive. Heading into yesterday the 5-day historical volatility of the S&P 500 Index was below 2% while the VIX was rocketing over 20. That is a huge disconnect, one that I can’t remember seeing ever.

That being said, we could see a significant, if short-lived, volatility jump. On the Brexit, the VIX climbed above 22 before the vote and did get above 26 after. But more importantly, the SPX fell 100 points. Since we are at roughly the same starting point right now, and there is technical support at the 2000 level, we could look at out-of-the-money puts or put spreads. The 2075/2030 November expiration put spread can be bought for $10. That would have a payoff of $35 or 350% if the SPX was below $2030 on expiration (the SPY spread could be done in a similar manner).

The SPX going down to 2000 is a low probability event, with the delta of the 2030 options suggesting just a 25 percent probability that the Index will be below that level at expiration. But if position sized correctly, this could make sense for that downside exposure if the market doesn’t like the outcome of the election.

If you are an option trader, then at least having a mix of bullish and bearish positions on different underlying stocks makes good sense. You know you will likely lose on some of them, but given the asymmetrical payoff of options, and the potential binary outcome, this still could be a good way to approach it.

Lastly, there are the VIX products, like the VXX. We have seen, and will continue to see, a lot of folks recommending buying the VXX or calls on the VXX. And there is no question that it could make big gains. It is already up 20 percent in the last week and had been known to double in short order in the past. The term structure of the VIX futures is supporting it as they are in backwardation making this an opportune time to buy the VXX unlike when those futures are in contango (if that doesn’t make any sense you probability shouldn’t be trading the VXX). But you are still very likely better off using puts or put spreads that VIX products directly.

It is entirely possible that this market rips to the upside after the election, and likely even more so given the selling we have now – “sell the rumor, buy the news”. But anything can happen. So approaching this with the understanding that we truly could have a binary outcome is a prudent thing to do. It could protect your portfolio and potentially allow you to profit nicely – whatever the outcome.

Trading this election? We’d love to have you join us next week to Trade The Election.

Chris McKhann

Chris McKhann

Chris McKhann has been involved professionally with the stock market for more than 15 years and specifically with derivatives for 12 of those. He started as a stock broker, but quickly moved on to options and futures trading. He spent some time as the Derivatives Product Manager for TD Ameritrade. He was the chief analyst and hedging strategist for OptionMonster. He has been an options trading educator and content provider for many years. His writing and analysis has been featured on Reuters, the Wall Street Journal, Forbes, TheStreet, CNBC and internationally. He has also designed and traded option and futures strategies for prop trading firms and hedge funds as well as managed accounts.

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