Trades for a Low-Volatility Market

This year -- the year after a presidential election -- is the poorest-performing year in the presidential cycle. The average change in the SPX in a year after a presidential election was +3.07%. The best year in the cycle is the year before a presidential election, which on average was up 19.32%. The next best year is the presidential election year itself, which on average was up 9.29%. The third-best year is the midterm election year, which on average was up 5.49%. Maybe we are looking at a tough year for the markets once again.

Strategies

It seems this is not a year that will lift all boats. Strong stock-picking discipline or quantitative modeling will be the key. For those with a derivative bias, it seems this will not be a year to be long volatility. Volatility will be slightly up or slightly down, but it will not move with any ferocity in any direction. Selling volatility and hedging may be optimal, despite option volatility being low.

Finally, this will be a year of singles and doubles. I think momentum and momentum traders will take a holiday. Sure, we will have our Taser of 2005, but expect a more subdued market. Statistical strategies will work well. Look for good pairs trades with predictable variation surrounding mean reversion.

Conventional wisdom so far has proven wrong as January 2005 has started off quite poorly. Conventional wisdom also is betting on a huge spike in long-term bond yields, raw material costs and energy prices. I think the contrarian views to these beliefs will be victorious.

Here are some examples of trades. (We are exploring some of these but may not have acted yet.)

If you think the SPX will remain range-bound for the year and will not make a significant move, look at selling a strangle (simultaneous sale of an out-of-the-money put and call). With the SPX around 1180, I looked at the selling in the December 2005 1050 puts and December 2005 1300 calls. This strangle would give profit of about $40. It would become money-losing if the SPX closed below 1010 (down 14.4%) or above 1340 (up 13.55%). The most profit would be $40 if the index closed between 1050 and 1300. Between 1010 and 1050 or between 1300 and 1340, profit would be between $0 and $40.

Think stodgy. Think boring. Think defensive. Think Kimberly-Clark (KMB - commentary - Cramer's Take), for example. A trader could buy the stock for $64.50 and sell covered the January 2006 75 strike calls for $1.25. Add to that the $1.60 in dividends expected at the current payout. Net cost would be $61.65, which gives 4.42% of downside protection. On the high side is a possible $75. If you are still concerned, you could invest some of the dividends and call premium to buy the 60 (about $2.50) or 65 (about $4.30) strike puts, which will give you hard downside protection but cut into some of the upside profit.

If it looks like momentum is going to dry up, look for a momentum-crushing pairs trade. Here are some examples:

---

At the time of original publication, Rothbort was long Novell, McDonald's, PalmOne amd Research In Motion, long calls on McDonald's and short Red Hat, although positions can change at any time.

Scott Rothbort has 20 years of experience in the financial services industry. In 2002, Rothbort founded LakeView Asset Management, LLC, a registered investment advisor based in Millburn, N.J., which offers both individually managed accounts and a hedge fund to its clientele. Prior to that, Rothbort worked at Merrill Lynch for 10 years. Rothbort holds an MBA in finance and international business from the Stern School of Business of New York University and a BS in economics and accounting from the Wharton School of Business of the University of Pennsylvania. He is an adjunct professor for the Stillman School of Business at Seton Hall University.