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Hedging the Election
Most Americans would like to strangle politicians -- and now they can.
In the options market, a "strangle" strategy positions investors to profit if election results significantly move the market. Strangles are created by buying bullish calls and bearish puts with different strike prices to bet on price movements outside the narrow range defined by the options.
A strangle, for example, with options on the DJX, which represents 1/100th of the Dow Jones Industrial Average, makes sense if the Dow sharply rises or falls on election results.
To be sure, predicting the market's directional response to the election is as difficult as prognosticating if Republicans maintain control of Congress. Midterm elections are usually referendums on the president's performance, but this year's vote is complicated by issues normally debated in presidential elections, such as war, the economy and health care.
This is why Michael Schwartz, Oppenheimer's chief options strategist, is advising clients concerned about election volatility to buy DJX "strangles." With the DJX now trading at about 120.25, he recommends buying DJX November 121 calls for 60 cents and November 119 puts, also for 60 cents.
The DJX strangle begins paying off the further DJX rises above 122.20, or falls below 117.80. In other words, DJX needs to gain 1.6% or fall 2%, which is well within the range of the Dow's average move during midterm elections.
For 18 midterm elections -- since 1934 -- the Dow gained an average of 2.9% starting with the close of trading five days before the election, and ending three days after, says Jeff Hirsch, editor of Stock Trader's Almanac.
The cause of the rally seems driven by investor psychology more than anything else. Many bear markets start during midterm years, but start to rally higher after bottoming in October. Also, major military movements have tended to start in the middle of presidential terms. These negative facts may produce "an inner bullish feeling," among investors, the almanac hypothesizes, who feel they can make a change for the better by voting.
Yet, the Dow's midterm-rally phenomenon is not guaranteed. A few times history has not been prologue. In 1994, when Republicans gained control of Congress for the first time in 40 years, the Dow declined 1.6%.
Moreover, when the president's party experiences double-digit losses of House seats, the Dow's average eight-day gain was 2.3%. Conversely, when there were no losses or single-digit losses, the Dow gained 3.4%.
"Midterm elections are often an important inflection point for the market," Hirsch says, "while presidential elections, though seemingly more influential, impact the market less unless something silly goes on like a contested election in 2000."
While history often favors bulls over elephants and donkeys, there is no guarantee the market will advance, which is why the strangle is an attractive non-directional strategy.
"There's a lot of uncertainty on Wall Street about how the market reacts to the election. The strangle lets investors participate from any price movements that may occur," Schwartz says. Options prices on indexes are also near the lowest levels of the year, driven down as the Dow and other barometers have advanced strongly.
While the DJX strangle lets investors trade the broad market, they can apply the same strategy to exchange-traded funds that focus on specific sectors that may gyrate if Democrats win the House, such as pharmaceuticals and finance.
In some ways, "strangles" are Wall Street's equivalent of Washington's "Potomac Two-Step," which occurs when congressmen say one thing, and do another. This is not lost on Schwartz.
"Strangle the market," he says, "it's potentially more profitable."
(C) Barron's Nov 2 2006
Most Americans would like to strangle politicians -- and now they can.
In the options market, a "strangle" strategy positions investors to profit if election results significantly move the market. Strangles are created by buying bullish calls and bearish puts with different strike prices to bet on price movements outside the narrow range defined by the options.
A strangle, for example, with options on the DJX, which represents 1/100th of the Dow Jones Industrial Average, makes sense if the Dow sharply rises or falls on election results.
To be sure, predicting the market's directional response to the election is as difficult as prognosticating if Republicans maintain control of Congress. Midterm elections are usually referendums on the president's performance, but this year's vote is complicated by issues normally debated in presidential elections, such as war, the economy and health care.
This is why Michael Schwartz, Oppenheimer's chief options strategist, is advising clients concerned about election volatility to buy DJX "strangles." With the DJX now trading at about 120.25, he recommends buying DJX November 121 calls for 60 cents and November 119 puts, also for 60 cents.
The DJX strangle begins paying off the further DJX rises above 122.20, or falls below 117.80. In other words, DJX needs to gain 1.6% or fall 2%, which is well within the range of the Dow's average move during midterm elections.
For 18 midterm elections -- since 1934 -- the Dow gained an average of 2.9% starting with the close of trading five days before the election, and ending three days after, says Jeff Hirsch, editor of Stock Trader's Almanac.
The cause of the rally seems driven by investor psychology more than anything else. Many bear markets start during midterm years, but start to rally higher after bottoming in October. Also, major military movements have tended to start in the middle of presidential terms. These negative facts may produce "an inner bullish feeling," among investors, the almanac hypothesizes, who feel they can make a change for the better by voting.
Yet, the Dow's midterm-rally phenomenon is not guaranteed. A few times history has not been prologue. In 1994, when Republicans gained control of Congress for the first time in 40 years, the Dow declined 1.6%.
Moreover, when the president's party experiences double-digit losses of House seats, the Dow's average eight-day gain was 2.3%. Conversely, when there were no losses or single-digit losses, the Dow gained 3.4%.
"Midterm elections are often an important inflection point for the market," Hirsch says, "while presidential elections, though seemingly more influential, impact the market less unless something silly goes on like a contested election in 2000."
While history often favors bulls over elephants and donkeys, there is no guarantee the market will advance, which is why the strangle is an attractive non-directional strategy.
"There's a lot of uncertainty on Wall Street about how the market reacts to the election. The strangle lets investors participate from any price movements that may occur," Schwartz says. Options prices on indexes are also near the lowest levels of the year, driven down as the Dow and other barometers have advanced strongly.
While the DJX strangle lets investors trade the broad market, they can apply the same strategy to exchange-traded funds that focus on specific sectors that may gyrate if Democrats win the House, such as pharmaceuticals and finance.
In some ways, "strangles" are Wall Street's equivalent of Washington's "Potomac Two-Step," which occurs when congressmen say one thing, and do another. This is not lost on Schwartz.
"Strangle the market," he says, "it's potentially more profitable."
(C) Barron's Nov 2 2006