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Preparing for Doomsday: Options Trades for the Debt Ceiling Crisis

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Mark Wolfinger addresses the question on every options trader's mind: how to prepare for debt-ceiling endgame? 

Everyone knows that the United States cannot default on its obligations. The results would be catastrophic for the whole planet.

We all know that something will be done in time. Don’t we? Surely those members of Congress who say that defaulting is not such a big deal are joking. However, just in case…

I find it difficult to believe how complacent everyone is. In my opinion, VIX ought to be more than 30, if not 40. You'd think on the brink of a potential economic disaster, investors would be buying puts to protect their portfolios – as I said, just in case. However, I see options that look downright cheap. Not necessarily inexpensive by normal standards, but when there is a potential disaster in the news – no matter how unlikely – why would puts stay so cheap? Why isn’t the bond market crumbling?

I don’t know the answer, but I know this. If I had a big stock portfolio, it would not be un-hedged these days. If I wanted to place a cheap wager, I’d own a few puts. True, the risk of buying puts is that you can lose 100% of your initial investment. But for some, the protection that hedge could afford is worth the cash spent. Also, if the idiots in Washington do come to an agreement, isn’t it possible that a fierce rally could be the result? If one wanted to place an inexpensive wager, one could own a few puts and a few calls. 

  

What to do?


It’s a gamble, but anytime anyone buys options there's a calculated roll of the dice involved. Speculative-minded options traders could buy a few index strangles. In this advanced play, you're hoping for a big swing in a short timeframe, but you aren't sure in which direction. It's a costly multi-leg trade that requires an explosive move in the underlying, but this scenario in Washington suggests nothing so much as a catastrophic reaction, if a deal isn't reached on a deadline. (If you're wrong, the max risk of this trade is limited to the cost of the options. Don't forget to factor in commission, too.) It’s not necessary to be greedy.

An alternative play would be to own some call and put backspreads. These are defined as a spread in which more options are bought than are sold. For example: buy 10 XYZ Mar 90 calls and sell 5 XYZ Mar 85 calls. Positive gamma - what Brian Overby calls "the acceleration Greek" - could be your friend if something big occurs in the marketplace. (If you're unfamiliar with the term, check out this video on gamma for options traders.) Of course, you could also incur the backspread's max potential loss - that occurs if the stock moves in the direction you want, but not quite enough.

A very inexpensive choice suitable for experienced traders comes with limited gains/losses. It’s the ratio condor. In simple terms, it involves trading two different 10-point index iron condors. Traders usually choose iron condors that are adjacent, or separated by at most one strike. In this case, a trader may decide to buy two of the farther OTM iron condors and sell one of the closer-to-the-money iron condor. The cash outlay will be small, but the profit potential is $1,000 (less the position cost) per unit.

 

Example:

Buy 2 INDX Aug 1500 puts
Sell 2 INDX Aug 1510 puts

Sell 2 INDX Aug 1700 calls
Buy 2 INDX Aug 1710 calls

 

Buy 1 INDX Aug 1530 put
Sell 1 INDX Aug 1540 put

Sell 1 INDX Aug 1730 call
Buy 1 INDX Aug 1740 call

A sufficient move could push the puts or calls ITM and a profit is earned. However, like all options trades, this one comes with risks. You'll need to reckon in the max potential loss for both  iron condors. (For a single iron condor, max risk is limited to the difference between the first two strikes, minus the net debit paid.) Also remember: commissions for a multi-leg trade like this can be considerable. To open both parts of the ratio condor described above, you'd pay $10.15+$7.55 or $17.70, just to open the position. The market move needs to be big enough not just to clear a profit but also to break-even on this commission charge.

Each of the strategies outlined above pays off in a big move and loses when if the move does not occur. Know the risks of each trade and proceed with your eyes open.

If it is this easy to own positive gamma when the world may come to an end, I must conclude that the world is not coming to a financial end. But I am a bit confused that no seems to be afraid.

 


   

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Regards,

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options available at http://www.tradeking.com/ODD.

 

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Mark Wolfinger does not hold any positions on the securities mentioned in this post.

 

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