How to Play the Presidential Election With Derivatives

NEW YORK (TheStreet) -- As of this writing, December S&P 500 futures are trading at 1,417, up 5 handles on the session.

So far, we are seeing some follow-through buying -- and likely some short covering as well -- ahead of this evening's tight election. The market failed to take out sell stops below the 1,400 handle on the downside, and now some back-and-fill trade should be expected.

Of critical importance on the upside will be a test of an overhead trendline coming in at the 1,445 area. Usually, but not always, markets tend to come back and retest a trendline or trading range following a breakout.

During Friday's session, the S&P 500 attempted to do just that, reaching a high of 1,431.50 following better-than-expected non-farm payroll numbers. However, the gains were quickly undone. The overhead trendline came in at 1,441, and thus the market fell a little bit short of a "true test." Perhaps we are heading for that test now.

We will see in the coming days. Everyone has their own opinions on who will win the election and how it will affect the markets. I am of the school of thought that it is best to let others try to "forecast" what the market will do. I prefer to try to let the market tip its hand first, and then position accordingly.

Therefore, I think it is tough to make a directional bet here. In addition, these types of events tend to have a knee-jerk reaction that corrects shortly thereafter. By looking at implied volatility in S&P 500 options, I can look for ways to play this election and the uncertainty surrounding it without making a directional bet on the market.

On Monday, the VIX closed higher even as stocks rallied. When most investors think of the VIX, they think of a rising gauge when the market is falling and a declining gauge when the market is rising. As we know, this is not always the case. What we are seeing is pre-election jitters causing market participants to bid up both calls and puts.

As a matter of fact, the VIX has been flirting with "backwardation." For those not familiar with the term, this is when the front-month readings for the gauge are trading at a premium to the back-month readings. In other words, participants are more worried about the immediate aftermath of the election than what might happen down the road.

Currently, volume is a bit lower this morning, with the VIX trading around the 17.80 level. I suspect that as the day goes on, we will see those readings rising and going into positive territory as last-minute positioning causes options to be "juiced up." As a matter of fact, the 18-18.50 level has proven to be resistance on volatility for the past few months.

I suspect that this level will once again hold following the election. Therefore, I feel it makes sense to sell short-dated strangles in the S&P 500 looking for the "volatility crush" post-election. I would suggest looking at using the end-of-month options for November. I feel they can be sold far enough out of the money while taking in enough premium to justify the risk.

In addition, with only 25 days until expiration, these options should experience a very high rate of theta, or time-decay until expiration. The position I will outline below has unlimited risk. Feel free to contact me to discuss alternative ways of structuring a position with limited risk. Please note today is Nov. 6, and all trade information is based on the most recent data.

Sell the end of November 1,320/1,500 strangle for 4.6 points or better day order.

Risk on trade: unlimited.

Profit potential: premium collected minus commissions and fees. As stated above, profit potential is $1,060 after subtracting two round-turn commissions of $45 inclusive of all fees.

Please note mini-S&P contract may be substituted.

Futures and options trading is inherently risky and unsuitable for all investors. Past performance is not necessarily indicative of future results. Stop-loss orders intended to limit losses to certain amounts may not be effective because market conditions may make it impossible to execute such orders.

Commodity Futures Trading Commission disclosure for licensed brokers: This material is conveyed as a solicitation for entering into a derivatives transaction.

Matt Zeman is a trader at Kingsview Financial. He began his trading career as a runner in the grain pits at the Chicago Board of Trade before becoming an arbitrage clerk. Eventually he started trading equity options and stocks. Matt now is a full-time futures broker. He has been a frequent guest on CNBC, Fox and Bloomberg, and provides his views on the stock, bond and futures markets for financial media including Dow Jones, the L.A. Times and The Associated Press. Matt is a member of the Chicago Board of Trade, and carries series 3, 7 and 66 licenses.