Smart Investor: Preparing for election-driven market volatility: hedging strategies to consider

It’s D-Day for the U.S. markets—election week is here, and the stakes are high. As voters head to the polls, investors are bracing for possible turbulence, with the put/call ratio recently spiking to 1.61, the highest level since August 5, 2024. Back then, a surge in volatility shook the markets following a dramatic JPY carry-trade unwind, and this elevated put/call ratio suggests that investors are once again turning cautious.

In simple terms, more market participants are trading puts than calls, indicating a rise in hedging activity as they seek to insure their portfolios against potential downside. With key sectors like technology, healthcare, energy, and defense highly sensitive to policy outcomes, hedging strategies—such as buying SPX puts and sector-specific options—can provide a valuable buffer against election-driven market reactions.

For more insights into stocks that may be particularly sensitive to election outcomes, see the recent analysis from my colleagues here.

Why election outcomes shake the market

U.S. elections often introduce volatility as policies affecting taxes, regulation, and spending shift with new administrations. Traders adjust positions based on anticipated policy changes, which can create price swings across the market. While predicting the election outcome or its market impact is challenging, hedging can help investors protect their portfolios.

Important note: the strategies and examples provided in this article are purely for educational purposes. They are intended to assist in shaping your thought process and should not be replicated or implemented without careful consideration. Every investor or trader must conduct their own due diligence and take into account their unique financial situation, risk tolerance, and investment objectives before making any decisions. Remember, investing in the stock market carries risk, and it's crucial to make informed decisions.

Hedging the market with SPX puts

A simple method for broad protection is buying put options on the S&P 500 index (SPX), which appreciate in value if the index declines. SPX puts can capture immediate volatility or offer longer-term protection depending on the chosen expiration date. Slightly out-of-the-money puts (e.g., 2-5% below the SPX level) often strike a balance between cost and potential downside coverage.

Sector-specific hedging: targeting vulnerable areas

Some sectors are more exposed to election-driven policy changes than others. By focusing on these, investors can target the specific areas of their portfolio that may be most affected:

• Technology: Big tech may face regulatory scrutiny around data privacy and antitrust. Stocks like Amazon, Google, and Facebook are at heightened risk.
• Healthcare: Drug pricing and Medicare policy changes could impact insurers and pharmaceutical companies. Stocks like UnitedHealth Group and Pfizer are good candidates for sector-specific hedges.
• Energy: With energy policy at the forefront, renewable energy and oil companies face distinct election-related risks. Enphase Energy and NextEra Energy might benefit from pro-renewable stances, while traditional oil companies like ExxonMobil could face headwinds if policies favor stricter environmental regulations.
• Defense: Shifts in military spending or foreign policy could impact defense contractors. A hedge on major defense stocks may be prudent if spending priorities shift.

Using puts on these sector-specific stocks can be effective, though they may be more costly due to higher implied volatility in sensitive sectors.

Cost-effective alternatives: spread and collar strategies

Protective puts can be pricey, particularly with elevated volatility. Spread strategies, like put spreads, help manage these costs while still offering meaningful protection. Let’s look at an example: