This Day On The Street
Continue to site
This account is pending registration confirmation. Please click on the link within the confirmation email previously sent you to complete registration.
Need a new registration confirmation email? Click here

Analysis: VIX and the Debt Ceiling

TheStreet Premium Services

A complimentary preview
of Options-Profits Previews

The risk of a sizable market drop if Congress refuses to raise the debt ceiling is great enough that a hedge position is justified.

There are two areas of risk if the struggle within the GOP continues into late October and the Treasury runs out of borrowing capacity. The first risk is that of a fiscal guillotine, a swift and devastating cut in government spending that has been estimated at 32% of the federal budget. The deflationary effects of missed payments to Social Security, Medicare, and unemployment insurance recipients would be gradual, but the effect on consumer sentiment should be more sudden. The second risk is that of a debt default, of turning the one risk-free asset the world has left into just another set of risky paper. The effects are hard to predict, but for a good look at some of the details and risks, see this report from the Bipartisan Policy Center.

The Treasury Department has estimated that its debt limit would be reached "no later than" Thursday, October 17. The BPC report linked above pegged the "X date" - the day when Treasury wouldn't have enough cash on hand to meet its daily obligations - in a range from October 18 to November 5.

Projected range of the "X" date. Source: Bipartisan Policy Center

From the perspective of equity portfolio hedgers, this is the time to be adding protection, not a day or a week before the limit is reached. By then, assuming no political progress has been made, markets will already have started to price in a large risk premium, and hedgers who are late to the table will probably overpay for protection: overpay, that is, for protection that every reasonable person hopes will prove unnecessary. Expected events with known dates (or narrow date ranges) can be treated somewhat like corporate earnings reports: option implied volatility will rise ahead of the event as demand pushes option prices higher, and then after the event, implied volatility will drop even if the asset affected sees a large price change.

Sometimes it is possible to buy options well ahead of earnings and to see the increase in implied volatility offset most or all of the time decay associated with holding the options. We will be taking a similar approach here: entering a position well ahead of t he expected event because we don't expect to the net cost (time decay less increase in IV) to be substantial.

The attached risk dashboard gives us a quantitative look at where key risk variables are right now, relative to the past year:

Check Out Our Best Services for Investors

Action Alerts PLUS

Portfolio Manager Jim Cramer and Director of Research Jack Mohr reveal their investment tactics while giving advanced notice before every trade.

Product Features:
  • $2.5+ million portfolio
  • Large-cap and dividend focus
  • Intraday trade alerts from Cramer
Quant Ratings

Access the tool that DOMINATES the Russell 2000 and the S&P 500.

Product Features:
  • Buy, hold, or sell recommendations for over 4,300 stocks
  • Unlimited research reports on your favorite stocks
  • A custom stock screener
Stocks Under $10

David Peltier uncovers low dollar stocks with serious upside potential that are flying under Wall Street's radar.

Product Features:
  • Model portfolio
  • Stocks trading below $10
  • Intraday trade alerts
14-Days Free
Only $9.95
14-Days Free
Dividend Stock Advisor

David Peltier identifies the best of breed dividend stocks that will pay a reliable AND significant income stream.

Product Features:
  • Diversified model portfolio of dividend stocks
  • Updates with exact steps to take - BUY, HOLD, SELL
Trifecta Stocks

Every recommendation goes through 3 layers of intense scrutiny—quantitative, fundamental and technical analysis—to maximize profit potential and minimize risk.

Product Features:
  • Model Portfolio
  • Intra Day Trade alerts
  • Access to Quant Ratings
Real Money

More than 30 investing pros with skin in the game give you actionable insight and investment ideas.

Product Features:
  • Access to Jim Cramer's daily blog
  • Intraday commentary and news
  • Real-time trading forums
Only $49.95
14-Days Free
14-Days Free
Top Rated Stocks Top Rated Funds Top Rated ETFs