EQD Research: The U.S. Election And Opportunities In European Volatility

The third quarter of 2020 has come to a close with the markets now focused on a few potential issues that could impact the equity market and associated volatility expectations through the end of 2020. Resolution of the current pandemic, making sure lenient central bank behavior does not come back to hurt the financial markets, and of course the pending U.S. election results will consume traders’ attention over the next few weeks.

The known unknown in that list is the U.S. election. We know there will be voting on Nov. 3, but that is the end of what we know for sure. Typically, the result is known by the following day, with the last uncertain outcome occurring in 2000 when a winner was not declared until December. We are still just over a month from election day and the results are already being questioned, so unfortunately a repeat of that uncertainty may occur again, but there is also a high likelihood that the final outcome of the U.S. election may be known and settled just days after the polls close.

This will be the third U.S. election since VSTOXX futures started offering an opportunity for traders to gain exposure to expected volatility for the European equity markets. Despite both the 2012 and 2016 elections having very different outcomes, there are similarities between the behavior of VSTOXX and the associated futures leading up to and following the previous U.S. elections.

First, we took a look at where spot VSTOXX and the futures were trading on the last day of September this year and for the two previous election years which appears in the chart below.

VSTOXX Curves – Last Day Of Q3 2012 / 2016 / 2020

Data Source: Bloomberg

Needless to say, 2020 is a bit elevated relative to the previous two curves on VSTOXX terms structure chart. At first glance, there does not appear to be much similarity among the three lines on the term structure. However, for each of the three curves, the December VSTOXX contract is trading at a discount to November. As we will see shortly, in both 2012 and 2016 the November contract would trade below the December contract before November expiration. But first we should explore the day before and day after the elections in 2012 and 2016. In 2012 the VSTOXX curve moved higher in reaction to the re-election of Barack Obama. The curve shift was similar in fashion with the VSTOXX index and front three-month futures contracts.

VSTOXX Curves – Day Before And After 2012 U.S. Presidential Election

Data Source: Bloomberg

In 2016 there was an opposite reaction to the election of Donald Trump. On a day-over-day basis the VSTOXX Index dropped almost 4.00 points and the November VSTOXX future was down by 1.05 points.  That is of course the day-over-day change. At one point in the morning of Nov. 9, 2016, the November contract was up over 2.00 points.

VSTOXX Curves – Day Before And After 2016 U.S. Presidential Election

 

Data Source: Bloomberg

The day-over-day shifts in the VSTOXX term structure around the 2012 and 2016 election do not share much in the way of price action. However, the daily price changes for the November and December VSTOXX futures contracts do mirror each other. The chart below tracks the November and December VSTOXX prices from the last day of September in both 2012 through the November VSTOXX expiration date. Note the large dots indicate the day before and after the election results for each year.

2012 Nov. And Dec. VSTOXX Daily Prices End Of September To November Expiration

 

Data Source: Bloomberg

Over the course of October 2012 and into November VSTOXX expiration the two futures contracts drifted lower, which is typical VSTOXX futures contract behavior. Also of note, the December contract moved from a discount to a premium relative to November. The relationship between the November and December VSTOXX futures contracts played out in a similar way in 2016.

2016 Nov And Dec VSTOXX Daily Prices End Of September To November Expiration

 

Data Source: Bloomberg

The 2016 November VSTOXX future took a similar route from the end of September to November settlement as the 2012 one did. Also, November shifted from trading at a premium to December to trading at a discount, just like the price action in 2012.

The first observation from looking back at trading activity leading up to the last two elections is that November VSTOXX was lower on election day than it was on the last day in September. In 2012 it closed at 25.30 on the last day of September and finished election day (Nov. 6) at 21.20. November VSTOXX moved from 24.05 at the end of September to 21.75 on election day (Nov. 8) in 2016. Outright shorting volatility is a bit of a risky endeavor in 2020, but there are strategies, such as buying an in-the-money put or a bearish vertical spread that could profit from a drift lower in the November contract.

Another observation is that in both 2012 and 2016 the November contract was at a premium relative to December VSTOXX on the last day of September. In 2012, November was 0.50 higher than December and in 2016 November was 0.75 higher. Between that date and November expiration for each year December eventually traded at a premium relative to November. In 2012 it did not occur until after the election, while in 2016 the November contract traded to a discount relative to December in late October, so the timing was different in both years. On Sept. 30, 2020, November VSTOXX settled at 27.55 and the December contract finished at 26.60, a 0.85 discount, just like the previous two elections. If there is an expectation that as the U.S. election draws near or there appears to be more certainty about the outcome of this year’s presidential election a calendar spread shorting November VSTOXX and buying the December contract would make sense. Any deviation offering short November and long December exposure using a combination of November and December VSTOXX options is a viable alternative as well.

The year 2020 has been like no other in recent memory and a volatile U.S. presidential campaign season does have people on edge. However, once the election is over and a winner is declared, the markets will have one less potential unknown behind it. With a little more certainty about the state of the world, it is very possible that the 2012 and 2016 VSTOXX price patterns will repeat themselves.