By Vinícius Andrade and Barbara Nascimento Investors eager to trade on a Brazilian election that’s too close to call are prioritizing derivatives over outright bets after market favorite Flávio Bolsonaro gained ground on President Luiz Inácio Lula da Silva.

Markets are bracing for big swings in the Brazilian real, while options trading on the largest exchange-traded fund tracking the nation’s stocks has taken off. Neither candidate is expected to earn enough votes to prevail in Sunday’s first-round vote, but it will likely provide insight into how Lula — a leftist seeking a fourth term — will fare in a runoff against the eldest son of former President Jair Bolsonaro, who has seen a recent rise in the polls, shrinking the incumbent’s lead.

“We do anticipate seeing opposite initial market reactions depending on the outcome,” said Petar Atanasov, co-head of sovereign research at Gramercy Funds Management. “We expect fiscal reform momentum to be significant under Bolsonaro and accompanied by strong market optimism.”The options market shows how heavily risk is concentrated around Sunday’s vote. The real’s one-week implied volatility has surged above 31%, the highest since late 2022. The one-month measure — which captures both rounds of voting — has also gained but remains below 25%.

A Lula lead narrower than two percentage points over Bolsonaro in the first round would be positive for the right-wing challenger since many third-party candidates would likely shift his way in a runoff, Citigroup Inc. strategists including Dirk Willer wrote in a note. A gap of two to four points would still point to a “close race” in the second round, they said.

While Lula has, at times, been more pragmatic than some investors had expected, the country’s markets have largely lagged peers in his third term. The Ibovespa has underperformed gauges of emerging stocks and the S&P 500 Index in the span. The real was little changed, trailing main EM currencies including the Mexican peso and South African rand. Companies and families are bucking under the weight of double-digit interest rates, which have remained stubbornly high as the government resists a large fiscal adjustment.

Market participants say a Bolsonaro victory raises the chance of Brazil reining in a budget deficit that sits at more than 9% of gross domestic product. While he has yet to detail his economic proposals, Bolsonaro’s camp has touted plans for administrative reform and the sale of government-owned assets.

Prediction markets had Lula as the favorite until early September, but now put Bolsonaro’s chances of winning at roughly 60%. The improving odds have led traders to pursue bullish bets on Brazil, with banks from Citigroup to JPMorgan Chase & Co. recommending options bets on a stronger real to capture a potential post-vote rally.

“We expect the biggest surprise to come in the first round, with Flávio likely to finish ahead of Lula,” said Fabricio Taschetto, chief investment officer at hedge fund Ace Capital in Sao Paulo. “We might see a post-vote move that’s even greater than what’s already priced into implied volatility,” said Taschetto, who has used options for bullish wagers on the iShares MSCI Brazil ETF, or EWZ.

Open interest in EWZ options is at an all-time high of more than 9 million contracts, driven mostly by calls, which typically gain value when the underlying asset rises. Demand for calls on the benchmark Ibovespa index have also jumped since the end of August, with local hedge funds including Ibiuna Investimentos and Verde Asset Management telling clients they were using options to position for a potential rally.

The positioning isn’t one-sided. Alejandro Cuadrado, head of global FX and Latin America strategy at Banco Bilbao Vizcaya Argentaria SA, said the bank has seen elevated interest in digital options overall. Corporates and real-money investors have focused more on structures that pay if the Brazilian currency strengthens, while others have sought protection against a weaker real, he said.

Local bonds are also finding favor ahead of the vote. Investors including Gramercy, Ninety One and M&G Investment Management say yields offer enough compensation to stay invested through the election, while leaving room for sizable gains if the next administration implementseconomic reforms.

“Local rates offer the most positive asymmetry into elections,” said Christine Reed, an emerging markets portfolio manager at Ninety One. With inflation-adjusted rates firmly in restrictive territory, Brazil’s central bank has “space to continue its cutting cycle regardless of who is elected,” she said.

At M&G, senior emerging markets debt fund manager Carlos Carranza is “slightly long” Brazilian local markets, seeing room for a rally in real-denominated debt.

“A credible and timely commitment to fiscal consolidation could trigger a significant market rally, whereas continued uncertainty may keep pressure on Brazilian assets,” he said. “Yields are high enough to compensate investors for fiscal uncertainty.”