As we approach the U.S. elections and a highly anticipated Federal Reserve meeting, the options market is showing interesting signals, especially when compared to previous election cycles. Historically, political events and central bank meetings tend to bring heightened volatility, but this time around, the cost of hedging that risk appears unusually cheap. Let’s dive into what’s happening.

Election-Day Volatility vs. Past Elections

In early October, the implied move for the S&P 500 on Election Day was around 2.7%. However, as we near the date, this has dropped to just 2%. For context, the implied move reflects the options market’s expectations for how much the S&P 500 will fluctuate. A lower number suggests that traders are not pricing in as much movement – or volatility – as they did earlier. This contrasts with prior election periods when volatility pricing has typically been much higher.

There could be a few reasons for this. Perhaps markets are assuming the outcome is more predictable, or maybe they’re underestimating potential surprises. Either way, compared to past elections, this level of implied volatility seems low and potentially underprices the risks that still loom.

FOMC Volatility is Rising

While election volatility appears subdued, the Federal Open Market Committee (FOMC) meeting on November 7th tells a different story. The implied move for the FOMC has increased from 1.2% earlier this month to 1.4% now. This suggests that market participants are starting to factor in more risk around this pivotal meeting, where the Fed could signal its stance on future interest rate hikes.

A Strategic Trade Idea

According to BofA’s Quantitative Derivatives Strategy (QDS) team, one way to navigate these dynamics is by using a put spread strategy. They recommend buying the SPY Nov 575-555 put spread for $3.35 (or 0.57% of the notional value), which could provide a 6x maximum payout if the S&P 500 drops by 5% over the next 3.5 weeks.

What’s especially notable here is the cost differential. The November regular expiration costs just 0.22% more than the November 8th expiry, which covers election week. For just a slight premium, investors can gain protection not only for the election but also for the FOMC meeting on November 7th and the Consumer Price Index (CPI) release on the 13th. This makes the regular November expiry attractive for those looking for a broader hedge against several upcoming risk events.

Sector Focus: Financials Volatility

At the sector level, BofA QDS highlights financials as an area where owning volatility could pay off. Financials have been rallying strongly since the summer, up 16% since May, buoyed by solid earnings reports. However, this sector also faces significant risk from a combination of factors, including a potentially hot Non-Farm Payroll (NFP) report, an unfavorable election outcome, and a hawkish FOMC stance.

Financials are particularly exposed because their earnings and performance are closely tied to interest rates, which could move significantly based on the election and FOMC decisions. According to BofA, financials had the highest exposure in the Russell 1000 index to these election and FOMC risks, and they believe options markets are underpricing these risks.

The current market environment presents a fascinating puzzle for investors. Election volatility appears cheap compared to past cycles, but the risks associated with the election, the Fed meeting, and other macroeconomic events remain significant. As such, taking a strategic approach to hedging with options, particularly in sectors like financials, could help investors navigate these uncertain waters.

Investors should consider whether the current low volatility pricing presents an opportunity to protect portfolios from potential shocks, especially with key events looming on the horizon. Whether it’s using a put spread strategy or owning volatility in specific sectors, there are ways to stay ahead of the game in what could still be a volatile few weeks for markets.