Before I retired I was an option trader for 24 years. Unfortunately it makes me think about the world in a slightly cockeyed way: it always gives me innocent delight to see people behaving in a way that is in line with option theory.
Theresa May’s announcement today of an early general election in the UK is a classic case.
Consider the facts she faced before making the decision:
- Her party is massively ahead in opinion polls (+10-20% according to recent surveys)
- Her personal polling lead against her main rival – Jeremy Corbyn of the Labour party – is by even more of a crushing margin. (‘Who would make the better Prime Minister?’ is a contest she wins 50% to 14%).
- She is in the middle of a very intense and complex negotiation (Brexit) …
- … and while she negotiates she has a wafer thin majority which can be overturned by a single digit number of backbenchers staging a revolt.
She has the option to call an election within the five years of Parliament – it is indeed a real ‘call option’. She is not meant to have this option – since the Fixed-term Parliament Act of 2010 she’s meant to wait until 2020 for the next election since the last one was in 2015. But in reality this brake can be overridden with a 2/3rd vote in the House; the Labour Party is on record as saying that they would back this move.
So her decision resembles the one facing the owner of an American option – an option that, unlike a plain old European option, can be exercised at any time, not just at expiry.
When should the owner of an American option exercise it?
Option theory tells you the answer. It is when the time value of the option is outweighed by the advantages of early exercise.
In financial markets, this usually happens when an American call option to deliver a high yielding asset is deep in the money. There is not much time value in the option (it is so far in the money) and the advantage of having the asset now (the ‘carry’ or yield for the remaining lifetime of the option) is very great.
These are exactly the circumstances that face Theresa May. Her option is deep in the money – could the poll leads realistically get that much better for her? And besides, there are always ‘events, dear boy’ to screw things up if she waits.
The advantages of going for an election now are also obvious. If she wins a bigger majority (an odds-on certainty as things stand currently in the bookmakers) the ‘negative carry’ of having to continuously appease her own backbenchers will disappear to a large extent. Given the psychic strain Prime Ministers go through keeping their own party in line (e.g. John Major 1992-1997) that probably feels like a very high yielding change for the better.
Overall then, the move today strikes me as an extremely rational one – even if the timing doesn’t give her party the extra leg up of the favourable boundary changes that are in the pipeline.
No wonder she chose to forget all her recent assurances that there would be no snap election. One thing that options traders are famous for is changing their minds.
And cold, cynical rationality, let’s not forget that.