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Monday, November 5, 2012 - 18:00
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Monday, November 5, 2012 - 18:00
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Monday, November 5, 2012 - 18:00

An Election Trade That Could Yield 27% Whether It's Obama or Romney

Monday, November 05, 2012 6:00 PM

With an incredibly close presidential race, uncertainty about who will be in the White House next January will almost certainly have an impact on the stock market. Each candidate has different visions, and once in office will adopt policies that benefit some sectors of the economy while potentially hurting others. Some investors and traders are waiting on the sidelines and will enter positions after the results are known. This action is likely to create volatility in the stock market, and that is a tradable idea.

Volatility is usually associated with the CBOE Volatility Index (VIX), a widely followed indicator that is not directly tradable. Individual traders can buy several ETNs that are based on the VIX, but they are constructed in different ways and have significant tracking errors over time.

The chart below shows that during the past two months, VIX is virtually unchanged but VelocityShares Daily 2x VIX Short-Term ETN (NYSE: TVIX) is down more than 40%.

Instead of using an ETN, traders can use options to trade volatility indirectly. As volatility increases, there are generally large price moves in a number of stocks and ETFs. These price moves will also be reflected in the values of options, and with a combination of puts and calls, traders can benefit from an increase in volatility without needing to take a position on the market direction.

Traders can use options on an ETF that tracks almost any stock market index to benefit from volatility, but iShares S&P 100 Index (NYSE: OEF) is an ETF that offers traders an opportunity to open a low-cost options trade right now. This index includes the 100 largest stocks in the S&P 500 index and its short-term movements are highly correlated with ETFs that track the S&P 500 (NYSE: SPY) and Dow Jones Industrial Average (NYSE: DIA).

The chart below shows that these three ETFs have made nearly identical moves during the past two months.

The advantage of OEF relative to SPY or DIA is that it trades at a lower price, and lower priced stocks generally have lower priced options. OEF is trading at about $65.49 a share. December $66 calls cost about $1.05 and December $65 puts are about $1.35. A position consisting of one call and one put would cost $2.40.

A 5% move in OEF would result in a gain or loss of about $3.27 in the stock's price. If OEF gains 5%, it would be worth $68.76, and the call would be worth at least $2.76 while the put would be worthless, resulting in a 15% gain. A 5% decline pushes OEF down to $62.22 where the put would be worth at least $2.78 and the call would be worthless, giving traders a profit of 16%.

I believe that a move of that size or more could unfold in the days after the election. If it happens that quickly, the options would have additional value based on the time to expiration.

This is a trade for those who expect market volatility to increase before mid-December. The risk is small and the potential payoff is large if there is a 5% move in stocks before the options expire.

Action to Take --> Buy one OEF Dec 66 Call and one OEF Dec 64 Put for a combined price of $2.75 or less. Do not use a stop-loss. Set price target at $3.50 for either the call or the put (while the other expires worthless) for a potential 27% gain in seven weeks.

This article originally appeared on TradingAuthority.com:
An Election Trade That Should Yield 27% Whether It's Obama or Romney

Amber Hestla does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.