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How to Hedge Your Portfolio for the Election

November 6, 2012

The election this week has sparked countless articles about the likely effects of an Obama or a Romney win on various sectors of the economy, but in the short term, traders should focus not on the effects of a win by one party, but on the effects of an unclear outcome for either party. The FX team at Citi recently called a disputed electoral outcome the “biggest political risk” facing markets right now:

hedge for the electionWe view most of the recent price action in G10 FX (with the possible exception of the USD/JPY rally) as being the result of squaring up ahead of the US election and 18th National Congress of the Communist Party of China. The biggest political risk is the potential that the US result won‘t be known due to the combination of a tight election and re-count/mail-in issues in swing states.

Ohio is an epistemic minefield. There are as many as 200,000 absentee ballots outstanding, and if the voters who have not returned those ballots vote in person instead, the provisional ballots they cast cannot be counted, by law, until November 16. But those ballots might well determine the outcome in Ohio. So the clearest path to an undisputed electoral outcome would be for the winning candidate to win independently of the outcome in Ohio. The political science professor who writes  at Gin and Tacos explains an alternate swing state outcome that avoids Ohio:

The three key states are New Hampshire, Colorado, and Nevada. Before I launch into the explanation, let me clarify some of the assumptions. I have been as generous to Romney as possible in this scenario, giving him Florida, Virginia, and North Carolina. If Obama wins any one of those three, Romney is basically toast. But I’m going to assume for the moment that Romney wins them and we are faced with an extremely tight race to 270. Even coloring those three large states red, if Obama wins NH, CO, and NV then he cannot lose even if he loses Ohio.

Despite the trend in favor of Obama in recent weeks, there is always the possibility that polls in those non-Ohio swing states might be wrong. We are expecting an Obama win by a comfortable electoral vote margin, but traders who want to hedge against the possibility of a market roiled by an unclear outcome can buy weekly puts on the S&P 500 as short-term hedges.

The SPX November 1410 puts expiring on Friday the 9th recently traded for about $14.50. If all goes smoothly and there is a clear winner, the puts can be sold at the cost of just a couple days of time decay and whatever volatility premium is currently priced in; if the route to victory goes through Ohio, after all, and markets tumble in reaction to an uncertain outcome, these puts will quickly gain in value.

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