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ON WALL STREET, it usually pays to be a contrarian and to do the opposite of everyone else.
When everyone focuses on the same event, and predicts the same outcome, the unexpected often occurs. Why? Because the crowd gets too excited or fearful and that almost always upsets the market's natural equilibrium.
Now, is a good time to hedge some bets just in case investor expectations are not met by actual outcomes. Most of Wall Street agrees with the consensus media opinion that Republicans will retake control of the House of Representatives on Tuesday, and reintroduce gridlock to Washington.
The crowd also has high hopes that the Federal Reserve on Wednesday will announce the second-phase of its economic stimulus program. The Street expects the central bank to announce that it will initially buy $500 billion in U.S. Treasury securities, and to indicate that it will buy up to $1 trillion. The other scenario posits that the Fed will buy $100 billion of securities, and commit to similar monthly purchases for the foreseeable future.
The "market" is so convinced of the election's outcome, and twice as primed for the second-phase of the Federal Reserve's quantitative easing, that the slightest hiccup could jolt stocks.
This is why it makes sense to consider buying "election protection," as Krag Gregory, Goldman's Sachs' derivatives strategist, is telling clients. Gregory, widely regarded on Wall Street as one of the most thoughtful volatility analysts, says the first week of November is filled with major macro-economic data, and yet the Standard & Poor's 500 options market is unusually sanguine, which creates opportunities to buy puts without paying a fear premium.
"Expectations for QE2 and the election are high and fear, as measured in options, has been cut in half," Gregory, known on Wall Street as the "Vicar of Volatility," advised clients in a trading note distributed to clients early Monday.
The Vicar says the "optimal downside hedge" is buying Standard & Poor's November 1125 puts, which recently cost $6.60, or SPDR S&P 500 ETF Trust (SPY) November 112 puts to protect against a 2.5% decline in the stock market.
Purchasing defensive put options is like buying travel insurance before stepping on an airplane. If the market crashes, the insurance pays off. Of course, should the market advance, you lose the money spent on the insurance policy, and get to enjoy your trip.
Comments: steve.sears@barrons.com
http://twitter.com/smsearsBarrons
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