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.

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