The time to buy insurance is when no one wants to buy insurance, says trader Kevin Muir

One trader thinks stock-market volatility will spike in the run-up to, and the aftermath of, the U.S. midterm elections on November 3. Yet, buying portfolio protection through put options on the S&P 500 (derivative contracts that increase in value when the index falls) has been getting cheaper.

Kevin Muir is a former institutional equity-derivatives trader and author of a closely followed Substack column on markets, The MacroTourist. In his latest installment, published Friday, he wrote that the chances of a disputed or chaotic election outcome are understated. The political and governmental turbulence this scenario could generate is mispriced by options markets.

Implied moves for midterm elections are more in line with pre-2018 levels.

Muir's thesis is based on the general impression among pollsters that President Donald Trump's popularity is flagging and that the Democrats will take control of the House, even while the Republicans retain the Senate. However, Trump will likely contest any unfavorable election results fiercely, Muir said. This is a possibility that Trump himself has flagged in some major set-piece speeches.

Muir's fears included Trump's funding court challenges in every "problematic" district, leading to confusion and delay. That would lead to a "whirlwind of what-happens-now? And stolen election" headlines. This will all lead to much higher volatility in financial markets, which, as traders and investors often say, don't like uncertainty.

Option markets have been making insurance cheaper as volatility - best measured by the Cboe Volatility Index VIX, or Wall Street's "fear gauge," is sitting at its low for the year after a relatively calm period through August, he noted.

Muir said that the implied volatility (the market's best guess of how much the S&P 500 SPX will fluctuate at that time) of December S&P 500 put options was trading around 16% in July, while today it is at 14%. Implied volatility in put options for the S&P 500 in November has also tumbled significantly, from 17.5% to below 15%. (As a general rule of thumb, an implied volatility of 16% suggests the market will move on average around 1% daily.)

This is why Muir said that "the market is vastly underestimating the dangers lurking under the covers."

Moreover, Muir cited research from strategists at Citadel Securities and Barclays showing that, on a seasonal basis, September and October are typically the worst months for risk-adjusted returns for the S&P 500. The VIX has also tended to rise over these two months. He also expressed concerns about over-exuberance in the AI sector - as evidenced by (NVDA) Nvidia's acquisition of Hugging Face, widening credit spreads and several other factors - but the potential electoral dysfunction has troubled him most.

Muir advised investors, "It's time to pick away at buying portfolio protection" because when volatility is repriced quickly, the moves can be explosive and too fast to act on. When insurance is this cheap, it's "a chip shot" to take advantage.

-Jules Rimmer