“It was all good just a week ago.”
Since I am still spending most of my time on bed rest, and you already know I do not particularly like trading around FOMC, I have a little more time than usual to write. I figured I would use some of it to put together something that will hopefully remain useful beyond this week, especially for those of you trading short-dated options with me.
We are five days away from the midterms. The Fed made another rate decision yesterday. We got GDP and PCE this morning. Implied volatility has been moving around, Treasury volatility remains elevated, and we have already seen several large overnight moves before the election has even arrived. There are a lot of opportunities for traders to confuse volatility with direction over the next week.
Historically, midterm years have given us plenty of volatility. Since 1930, the S&P 500 $SPX has fallen at least 5% during the September-October period in 15 of 24 midterm years. Looking at a different period, since 1974 the S&P 500 $SPX has averaged only about 1.7% from August 1 through Election Day. The three months immediately following midterms have averaged about 5.7%, with 11 of 13 periods positive, while the six months following the election have averaged about 12.4%, with all 13 periods positive. Fidelity's longer history going back to 1938 also shows the S&P 500 $SPX positive 12 months after a midterm election about 95% of the time.
I am not using any of those numbers to forecast where $SPY trades next Tuesday, next Wednesday or six months from now. I use them as context. Midterm years have frequently produced difficult stretches before the election, and historically the period after the uncertainty passes has been much friendlier. The average maximum drawdown across the last 10 midterm cycles was nearly 17%, which includes everything from a roughly 7% drawdown in 2014 to more than 25% in 2022.
In other words, a market getting violent before a midterm is not particularly unusual.
The mistake comes when traders decide that volatility has to mean bearish.
Many of you were here during the 2022 midterms and remember the enormous premarket move we watched during that week. Two mornings after Election Day, October CPI came in cooler than expected. Headline inflation was still an absurd 7.7%, but traders had expected 8.0%. Within minutes, expectations for the December Fed meeting changed dramatically. S&P 500 futures were up about 2.5% by 8:33 AM, Nasdaq 100 futures were up about 3.4%, and Treasury yields collapsed. The 10-year eventually fell nearly 30 basis points while the 2-year fell roughly the same amount. $SPY traders in our community watched what amounted to roughly a 20-point repricing develop around that morning and session.
The election did not magically create that move. The environment surrounding the election gave the market a lot to reprice, and one inflation report changed what traders thought the Fed would do next.
Keep that in mind this year.
Yesterday the Fed held the target rate at 3.75%-4.00%. That followed the September meeting, when the Fed unanimously raised rates 25 basis points into that range. Yesterday's vote was 10-2, with Lisa Cook and Beth Hammack both preferring another 25-basis-point hike. The statement also upgraded its description of economic growth from “solid” to “strong” while continuing to say inflation remains elevated.
That is a very different message from a Fed that has finished tightening and is simply waiting around.
Warsh did not give the market much forward guidance either (big surprise). Yesterday we actually saw the Treasury curve react in two different directions: the 2-year yield fell roughly four basis points while the 10-year rose about five and the 30-year rose around six. Stocks moved modestly higher. The market heard the same Fed decision and repriced different parts of the curve differently.
For those of you who have followed my bond-volatility discussions, this is a good example of why I keep telling you to watch more than the Fed Funds rate.
The Fed directly controls an overnight rate. It does not sit there manually setting the 10-year Treasury every morning. The long end also has to price growth, inflation, Treasury supply, term premium, fiscal expectations and what investors demand to lend money for a decade or longer. We can therefore have a Fed that pauses while the 10-year yield still moves higher. For something like $QQQ, where a large amount of value sits in expected earnings well into the future, that long-end move can continue applying pressure even though the Fed technically did nothing at the meeting.
Then we got this morning's data.
Q3 GDP came in at an annualized 3.4%, up from 2.2% in Q2. Investment, consumer spending and government spending all contributed. September headline PCE increased 0.5% for the month and 3.6% from a year ago, while core PCE increased 0.3% for the month and 3.1% year over year. Real consumer spending was basically flat for September even though nominal spending increased 0.5%. After the data, futures were pricing roughly an 85% probability of another Fed hike in December.
So within about 18 hours, traders got a Fed pause, two dissenters asking for a hike, an economy growing at 3.4%, and another inflation reading above target.
Welcome to trading.
The rate environment also changes how I think about the midterms because rates now sit underneath almost every major argument surrounding this market. Higher yields can pressure $QQQ, raise mortgage costs, tighten financial conditions, change the attractiveness of equities relative to bonds and alter how aggressively companies can finance expansion. Lower yields can reverse several of those pressures quickly. Oil can influence inflation expectations, which can influence yields. Election policy expectations can influence deficits and Treasury supply, which can influence yields. An employment report can change expectations for December in a few seconds.
For an options trader, those relationships eventually show up in the premium we are paying. Naturally, this is where I want newer options traders to pay especially close attention.
Implied volatility measures how much movement the options market is pricing. It does not tell you whether the expected movement is higher or lower. As uncertainty increases around something like FOMC, CPI, payrolls or an election, traders may become willing to pay more for options, which raises implied volatility and therefore raises premium.
That means being right about direction is not always enough.
If you buy an option while the market is pricing a huge expected move and the actual move comes in considerably smaller, premium can decline even while the underlying moves modestly in your direction. Once the event passes, some of the uncertainty that traders were paying for disappears. That is the volatility crush people talk about around major catalysts. The Options Industry Council specifically notes that a decline in implied volatility can offset gains from the underlying moving in the expected direction.
For people trading short-dated options, there is another problem. Gamma and Theta both become increasingly aggressive as expiration gets closer, particularly around at-the-money options. Gamma means Delta can change very quickly when $SPY moves. Theta means the extrinsic value you paid for disappears increasingly quickly as time runs out. The shortest-dated options give you enormous responsiveness when price immediately does what you need it to do, but they also punish hesitation, chop and reversals much more aggressively.
That is a tradeoff I want everyone to actually understand rather than simply deciding that 0DTE is good or bad.
If I buy an option with several days remaining, I give the trade more time and reduce some of the extreme Gamma and Theta sensitivity I would have with a same-day contract. I also pay more premium and carry more Vega exposure, which means changes in implied volatility can affect me more. If I use 0DTE, my Vega exposure is smaller, but Gamma and Theta become considerably more aggressive. There is no expiration that removes risk. You are choosing which risks you want more or less exposure to.
Around the midterms, I will generally be more willing to pay for a little more time when the setup warrants it rather than depend on the market completing my entire idea within a few hours. That does not mean I suddenly need two-week contracts for a day trade. Those of you who trade with me already know I often like giving myself several days when I expect the move to require more room.
The other adjustment is size.
If implied volatility rises, contracts become more expensive. I do not respond by using the same number of contracts just because that is what I traded last Tuesday. My maximum loss does not care how many contracts I normally buy.
If the same $SPY option that cost $1.80 under one volatility environment costs $2.70 under another, the risk per contract changed. My size needs to acknowledge that. This is exactly why I have spent years teaching volatility-adjusted size and why MAX LOSS comes before what you think the market is going to do.
The Rangefinder becomes useful here too.
We translate annualized implied volatility into an expected daily percentage move. An IV of 16 implies roughly a 1% daily one-standard-deviation move. An IV of 24 works out closer to 1.5%. Those are expectations rather than boundaries. Price is perfectly capable of moving beyond them, but they give us some idea of what the options market has priced before the session even starts.
If implied volatility expands going into the election, I expect the ranges to expand with it. I do not want to use the same expectations I had during a lower-volatility summer session.
I still heavily weigh whether $SPY has broken the premarket high and previous day's high before looking for continuation calls. I would rather let somebody else go first, wait for the retest and then see whether buyers remain aggressive enough to defend what they gained. For puts, I use the inverse: premarket low, previous day's low, break, retest, and whether sellers remain aggressive enough to keep price underneath them.
The faster the market moves, the less interested I become in being first.
That becomes particularly useful around an election because overnight movement can make the chart look completely different before the cash session begins. We have already had several decent overnight moves this month. Futures can spend hours pricing information while most $SPY options traders are not actively managing the same contracts the way they would during the cash session. By the time the opening bell rings, yesterday's perfect level may already be several points away.
This is where traders get smoked chasing.
If $SPY gaps down several points, breaks the previous day's low overnight and opens directly inside what we have been referring to as “The Hole,” sellers may keep going. They also may have already done most of the easy work before I ever had an opportunity to enter.
The same thing applies in reverse. If $SPY gaps aggressively higher through the previous day's high and premarket high and opens near the top of a larger range, you will never see me chase calls. I can wait and see where buyers remain aggressive once the cash session actually has liquidity.
This is particularly important when everyone becomes convinced they know what the election means for stocks. Guess what: you don’t. No one does.
Historically, markets have dealt with uncertainty before midterms and often performed well after that uncertainty clears. That does not mean Democrats winning something is bullish, Republicans winning something is bearish, divided government is automatically good, or any of the other shortcuts traders like to repeat. The actual market impact runs through policy expectations, fiscal spending, regulation, taxes, Treasury issuance, energy, trade and whatever the Fed is doing at the same time.
This year we also have an unusually important rates backdrop sitting underneath it. The Fed raised rates in September, paused yesterday with two officials wanting another hike, called economic activity strong, and then woke up this morning to 3.4% GDP growth and 3.6% headline PCE inflation. Rate markets now have to decide how much tightening remains necessary.
That can easily produce conflicting moves underneath the indexes. The 2-year can respond to the expected Fed path while the 10-year responds differently to growth, inflation and term premium. $QQQ can struggle while other sectors hold up. $SPY can look stronger than $QQQ because money is rotating underneath it. The $VIX can fall while Treasury volatility remains elevated. None of those combinations require something to be broken.
If you trade short-dated options like I do, I would keep a few things in the front of your mind going into next week. I would respect the wider expected ranges without assuming their direction, size positions using actual premium and MAX LOSS rather than a habitual contract count, give myself enough expiration for the trade I am asking price to complete, and remain aware that event premium can disappear quickly after uncertainty resolves. I would also give considerably more weight to the premarket high, premarket low, previous day's high and previous day's low before chasing a move that may have already happened overnight.
A bearish election-night move can reverse Wednesday morning. A bullish election-night move can fail at the cash open. Yields can move one direction while equities initially move another. $QQQ can lead $SPY into a reversal. Breadth can improve underneath a weak index. We have already watched this market absorb headwinds that looked terrible on paper, and we have watched apparently favorable macro conditions fail to produce the upside traders expected.
The 2022 midterm week should be enough of a reminder. CPI came in cooler, rate expectations changed in minutes, Treasury yields collapsed and equity futures exploded higher before most traders had finished their coffee. The people who entered that morning married to the idea that inflation was still 7.7%, the Fed was still hiking and stocks therefore had to keep falling learned very quickly how little the market cares about what we think will happen.
Next week can give us downside. It can give us upside. It can give us both.
What I am expecting is a market with more reasons than usual to move quickly, especially when the same election uncertainty sits beside a Fed that has not finished settling the rate question.
For a short-term options trader, that means I want better entries, appropriate size, enough time, and a set of rules before I start paying for somebody else's implied volatility.
As always, trade smart. - SP