Why Election Jitters Have Traders Chasing Butterflies

(Bloomberg) -- Heading into presidential elections, traders typically try to hedge their bets based on which candidate might win. This time around, U.S. markets are increasingly trying to gauge how big of a mess the aftermath might be. With President Donald Trump all but promising to dispute the results if he loses -- on top of coronavirus case counts creeping higher and stalled stimulus negotiations -- the Nov. 3 election has already become the most expensive event to hedge against ever. Here's a look at the factors driving trades not just in the so-called volatility markets, but in currencies, gold and even the Treasuries markets.

1. What is volatility?

Basically, how dramatically prices rise and fall in financial markets. Downward moves tend to attract more attention, as they typically fuel concern about what's coming next. The most well-known turbulence tracker is the Cboe Volatility Index, or VIX, which is often called the market's “fear gauge” because it tends to climb when stocks go down. It's calculated based on how much traders are paying for options and other contracts used to hedge against big swings in prices. The more they're willing to pay, the more volatility they expect.

2. What do the elections have to do with volatility?

It's not just elections -- contracts on the VIX typically rise in the days around an anticipated event that could disrupt markets, such as a Federal Reserve meeting or a new jobs report when uncertainty is high.

3. What's the worry about the election?

Ever since the pandemic forced widespread lockdowns this spring, election officials have been predicting a big increase in mail-in voting. That could delay ballot counting, making it difficult to declare a winner on Nov. 3. More recently, Trump has been calling the uptick in mail-in ballots a plot to rig the election. He's repeatedly declined to commit to a peaceful transfer of power, and has justified the need to quickly appoint a justice to replace the late Ruth Bader Ginsburg on the Supreme Court by saying that the court may need to resolve the election. Goldman Sachs cautioned that a delayed result is only a “tail risk” and not the most likely outcome, but markets have other things to worry about right after the vote: The Fed will meet the week of the election for the first time since 1984, while October's jobs report will be released that Friday; on the other side of the Atlantic, talks over the terms of the U.K's new relationship with the European Union could be reaching a climax.

4. What could an election mess do to markets?

A delayed or contested result could further fray nerves in a still-shaky stock market after the S&P 500's worst month since March. During the 2000 Florida recount battle, the S&P 500 lost over 4%, yields on 10-year Treasury notes fell 52 basis points and gold prices soared as investors piled into haven assets. This time, Wells Fargo analysts warn that a “significant delay” in election results could send benchmark Treasury rates to historic lows, while likely boosting the U.S. dollar.

5. What are investors doing?

For one thing, they're chasing butterflies. That is, a common way to bet on volatility is through a “butterfly trade” on the VIX. The trade amounts to buying one unit each of the first- and third-month contracts -- the “wings” -- while selling two units of the second-month -- the butterfly's “belly.” The trade bets on calm before and after the risk event while anticipating turmoil during it. Earlier this month, the wings dropped to the lowest level relative to the belly since VIX futures began trading in 2004, reflecting the lofty premium investors were willing to pay to protect their portfolios during the election.

Here's what else investors are using to hedge:

• November VIX futures -- which reflect the market's expectations for equity volatility through Nov. 18 -- are more expensive than October, while December futures prices have been creeping higher as traders increasingly anticipate a delayed result.
• Since June, currency traders have been using the yen to protect against volatility as far out as the January inauguration. Meanwhile, a JPMorgan Chase & Co. measure of swings for more than 20 global currencies has clawed back to the highest since the March meltdown.
• Even the Treasury market, where unprecedented Fed support has crushed volatility, is bracing for a contested result. Expectations for price volatility in three months versus four weeks are at a level only exceeded once in the past decade. Some traders have been buying options to hedge a potential rush of capital from investors fleeing stocks.
• It's gotten more expensive to protect against swings in the price of gold, too. Implied volatility on the $78 billion SPDR Gold Shares fund, ticker GLD, jumps in November and stays elevated through December's contract.

6. What if there actually is a clear-cut winner on Nov. 3?

Janus Henderson Investors, for one, thinks that would spark a sell-off in long-term Treasuries and send 10-year yields back to 1%, from about 0.66% currently. That could spell trouble for the equity market -- particularly for the technology stocks that have fueled much of this year's rally. Rock-bottom interest rates have helped justify the industry's sky-high valuations.

The Reference Shelf

• A QuickTake on what the VIX is and why financial markets fear volatility.
• How Wall Street is preparing to handle surging trading volumes on election night while working from home.
• Why the U.S. Postal Service is a top issue in the 2020 presidential election.

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