The ballot box and the ‘fear’ index

Please note: This article is more technical in nature than our typical articles, and may require some background knowledge and experience in investing to understand the themes that we explore below.

All data referenced in this article are sourced from Bloomberg unless otherwise stated, and is accurate at the time of publishing.

Key points

• With around a month until the US presidential election, what can the options markets tell us about where investors’ money is and how to prepare for the day after the result?  
• Reading too much into sharp market moves can be dangerous. The VIX index exploded to 38% from 18% in just two trading days. Rather than being down to Kamala Harris suddenly becoming the Democratic presidential candidate, a slew of bad corporate results and an unwinding of the Japanese ‘carry trade’ seem to have been largely responsible. 
• Investors tend to prioritise relevant economic news over political events. The main reason that the markets have been little moved by the US election race so far, is that investors were unable to translate political news into significant investment narratives or signals. 
• Options markets have already priced in an uptick in implied volatility around the election day.

Navigating uncertainty amid market-moving events demands investors' complete focus. It requires forward thinking, scenario analysis, risk anticipation and crafting an effective strategy. 

As the 2024 US presidential race enters its final month, investors are increasingly focused on election polls and expert analysis to estimate the potential impacts on their portfolios. Therefore, it is no surprise that the media is awash with articles from political and market pundits, examining the likely outcomes of the election and what this might imply for economies.

In this article, we explore what options markets can add to the debate.

The power of option-implied market signals

The implied volatility embedded in option premia reflects how much uncertainty, or risk, investors expect. Higher implied volatility suggests more uncertainty or price movements, often associated with fear or caution. Lower implied volatility indicates that investors are more confident or expect to see calmer market conditions.

As such, option markets are often used as a gauge of investor sentiment, particularly in times of extreme uncertainty or before major events, like elections or economic data releases.

A natural starting point in our analysis is to examine the behaviour of the Chicago Board of Exchange Volatility (VIX) index around US elections. The VIX is a widely recognised measure of investor sentiment, derived from S&P 500 options. It’s often referred to as the “fear gauge” because it reflects the market’s expectations for volatility over the next 30 days.

A closer look at recent polls and implied volatility

In the three months to 20 September, the options markets saw three notable spikes in implied volatility. The most dramatic surge took place in early August, when the VIX jumped from 18% to 38% in just two trading days. (Remember that past performance is never a guarantee of future performance). 

Examining the chart that compares election poll averages¹ to the VIX, it might be thought that this brief period of heightened market volatility is tied to the US election. Notably, President Biden announced his withdrawal from the race on 21 July, and vice president Kamala Harris was confirmed as the Democratic nominee on 5 August. Harris’ official nomination coincided with a shift in poll momentum, favouring the Democrats over the Republicans, as well as a spike in the VIX.

However, a closer look at financial market dynamics during this period reveals that the spike in implied volatility was most likely driven by a US “growth scare” triggered by weak economic data, alongside the unwinding of the yen ‘carry trade’².  

Similarly, the VIX increased by 4-5% on 24 July and 3 September, driven by concerns over several US company earnings reports and more disappointing economic news, respectively.

The ‘fear gauge’ and election polls: beware of spurious correlation

The difference between the average polling results for the Republican and the Democratic candidate, versus the VIX index, between 20 June and 20 September

Learning from the past

While financial markets can be influenced by political uncertainty, as the recent market example demonstrates, investors tend to prioritise relevant economic news over political events. 

The main reason that the election dynamics over the past three months have not been a major focus for investors, is that investors were unable to translate political news into significant investment narratives or signals.

To understand the relationship between elections and implied volatility, two key considerations arise. First, a shorter time frame leading up to election day (typically one to two months before the event) should be examined. Second, given the many factors that can affect markets, it's important to gather data from as many cycles as possible. By aggregating information across different election years, we can reduce the impact of investment conditions unique to a specific election.

In line with these criteria, the article analyses the VIX index since 1992, a period that covers eight election cycles. This era reflects various macroeconomic and geopolitical regimes, market cycles and different stages of technological innovation. As a result, it provides a comprehensive array of economic and political uncertainty, which is essential for our analysis.

Decrypting the VIX’s signature

To analyse the dynamics of implied volatility in this context, we calculate the difference between the weekly averages of the VIX for each of the eight weeks before and after the event, and the VIX level on the election day, for the elections spanned by our data sample. 

The next chart shows the evolution of the median value of this differential – derived from the eight election cycles since 1992 – starting two months before, and concluding two months after, the election date. Values below zero indicate that the VIX for a given pre- or post-election week was lower than the reading on the election date, while values above zero indicate a higher level. 

Additionally, we highlight the interquartile range – the shaded area that represents the range between the first quartile (25th percentile) and the third quartile (75th percentile) – to illustrate the distribution of realised outcomes.

The key observation is that, on average, the VIX dynamics generally follow a tent-shaped pattern around the election day. Implied volatility tends to rise in the two months leading up to elections, increasing by approximately 4%. The fear gauge typically reaches its peak one week prior to election day, after which it returns to pre-election levels within two months. 

However, implied volatility remains relatively sticky during the descent phase. This finding aligns with the well-documented volatility clustering effect, which stems from investors’ aversion to risk and loss.

The tent-shaped VIX signature around election dates 

The median (solid dark blue line) and inter-quartile range (shaded light blue area) of the difference between the weekly averages of the VIX, for each of the eight weeks before and after the event, and the level on each US election day between 1992 to 2020

What is already priced in?

Finally, we assess whether financial markets have already priced in the tent-shaped implied volatility dynamics, consistent with historical observations. To this end, we consider the spot one-month (1m) and two-month (2m) at-the-money (ATM) implied volatility (IV) of US indices, representing large and small caps, as well as eleven equity sectors. 

Using this data, we calculate the forward 1m ATM IV, which represents the expected spot 1m ATM IV (starting one month from a given observation date). If the ratio of forward-to-spot 1m ATM IV is greater than one, it indicates that markets expect a more turbulent period; if it is smaller than one, it suggests that more calm is anticipated.

To provide context for our results, we calculated these variables for selected indices on the last observation date in our sample (20 September), as well as the average over the past five years (2019-2024). It’s important to note that the current forward 1m ATM IV spans the period from 20 October to 20 November, straddling election day (to be held on 5 November). Therefore, it reflects market-implied volatility expectations for the two weeks leading up to, and following, the election.

Market expects a rise in implied volatility as we approach the election day

The current and five-year average (September 2019-September 2024) spot and forward one-month at-the-money implied volatility (1m ATM IV) for US large caps, small caps and eleven equity sectors

Our results indicate that the current spot 1m ATM IV is rather low, compared to the five-year average. This is consistent across large caps, small caps and various equity sectors, with implied volatility compression ranging from 3% to 10%. 

Nevertheless, the current forward 1m ATM IV is, in most cases, consistent with the five-year average. This indicates that the implied volatility term structure is upward sloping, suggesting that option markets expect more uncertainty around the election day. 

For all the indices considered – except for industrials – the current slope of the short-end of the implied volatility term structure is above the five-year average. Specifically, for large and small caps, as well as communication services, healthcare, materials and financials, the anticipated change in the spot 1m ATM IV over the next month surpasses the 95th percentile, based on measurements since September 2019.

This means that the market has already priced in the uptick in implied volatility, thus expecting increased fluctuations in equity markets around the election day. 

Is it time to be cautious?

To determine whether this should concern investors, we also examined the implied skewness in the selected markets, specifically the difference between the implied volatilities of 10-percent out-of-the-money puts and calls. In contrast to implied volatility, our results show that the expected changes in implied skewness are much more subdued. This is encouraging, as it suggests that markets do not anticipate significant shifts in positioning, indicating that no extreme hedging positions appear to be forming at this time. 

Naturally, investors should and likely will remain cautious around major events such as the US election. Being prepared for surprises and maintaining composure are crucial in these situations. However, it's important to remember that historically, elections and political events have had little impact on long-term portfolio returns. Fundamental economic data and secular trends are the primary drivers of markets in the long run, as can be seen in Elections or economy – which matters most for investors?