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By: Costas Bocelli — September 26, 2013

2 Ways to Hedge 11th Hour Volatility

Here’s a pop quiz:

Do you know what’s been the most fearful time for investors over the past year?

It wasn’t the Fed’s policy meeting in June where the committee first hinted at tapering their QE bond purchases...

It wasn’t the terrorist attack during the Boston Marathon on April 15...

Nor was it the inconclusive Italian elections in late-February and the subsequent messy bailout of Cyprus throughout the month of March.

Those events were high on the list, but top honor goes to Washington’s brinkmanship over the handling of the Fiscal Cliff at the year-end deadline.

It caused the CBOE volatility index (VIX) -- the “fear gauge” -- to briefly spike to 23, which has not only been the highest reading this year, but it’s the highest reading dating back to the summer of 2012 during a previous flare-up in the European sovereign debt crisis saga.

The VIX spikes when investors become fearful

As you can see in the VIX chart, volatility rises when investors become fearful.  It’s usually accompanied b meaningful declines in stock prices and surging premiums in related option contracts as investors scramble to buy protection.

But fear, no matter how intense it may get always seems to find a way to simmer down, and if you look at the chart you’ll notice that the VIX can plunge nearly as quickly as it can surge. 

Case in point: the time surrounding the Fiscal Cliff negotiations...

Washington put on its best game of chicken, but on New Year’s Day an eleventh hour deal was struck and the Bush tax cuts became permanent for 98 percent of working Americans who were set to go back to work the following day.

Those events led to a 3.5% pullback in the S&P 500, which sent the VIX to 23.  But the bookend trading sessions surrounding the New Year’s holiday deal produced a massive 4.5% rally that plunged the VIX out of the danger zone and paved the way for the springtime rally.

But many fiscal issues were not included in the deal and rather were kicked down the road, like the budget and spending reforms.  The debt ceiling too was pushed off until May, but the US Treasury has enjoyed a windfall of tax receipts and hefty payments from the GSE’s like Fannie Mae and Freddie Mac.  The Treasury has also has been utilizing creative accounting measures to temporarily circumvent the borrowing authority limit and buy additional time.

Well now the chicken has come home to roost and Washington must soon act.

By Monday, Congress must approve a new spending measure, because the current one is set to expire as the new fiscal year begins the following day.

And without a new bill, the government will be forced to shut down starting with the non-essential portions of the budget.

The House passed a continuing resolution to fund the government through mid-December, but the bill includes an amendment to de-fund President Obama’s healthcare law.

The bill now currently resides in the Senate, which is controlled by the Democrats.  They’re expected to strip out the healthcare provision and send it back to the House.

That might not occur until this weekend, which leaves about one day for the House to accept the Senate’s version or rework it and send it back to the Senate.  If that happens, we’re likely headed for a breach in the deadline which would prompt some form of a government shutdown.

But the real worry is over the debt ceiling.  The Treasury Secretary announced yesterday that the emergency steps taken to avoid hitting the debt ceiling will run out no later than October 17.

So between now and the next three weeks, markets could be facing the possibility of a government shutdown and an impasse on raising the debt limit.  The House has also added an amendment to their bill that prioritizes government expenditures in the event that the debt ceiling is not raised and remains $16.7 trillion.

President Obama has ruled out negotiations with Congressional leaders over the debt ceiling.  So who’s going to blink?  Because the last time Washington took a tough stance on the debt ceiling debate, the country came within hours of a debt limit breach.  The markets went berserk and the VIX exploded, hitting 48 just before a last minute deal was struck.

For now markets are relatively calm and the VIX is still maintaining a balmy reading of 14 which is towards the low side, historically.

It’s almost hard to imagine how complacent investors have remained with a potential hurricane of mayhem in the realm of near-term probabilities.

But that’s what causes markets to panic, as everyone prefers to waits for the fire alarm to trigger rather than heed warnings of noticeable puffs of smoke billowing in the background.

Here are two ways to prepare for volatility for your stocks over the coming weeks...

One way is to hedge a stock position by utilizing a basic covered call strategy. 

By selling calls (1 contract for every 100 shares that you own), you’ll create a limited hedge by the proceeds you collect from the sale.  The one trade-off is that upside appreciation above the strike price would be captured by the contract buyer, but remember that this is a defensive strategy and protection is the primary goal.  If the stock does trade higher and gets called away, it can always be repurchased at a later date and with broad markets near the top end of the trading range, you can likely remain a bit patient and find a good re-entry point.

I looked at the shares of Nike (NKE) yesterday afternoon, and with the stock trading at 69.00, the NKE October 70 Calls were trading at 1.70.  You could consider selling one call contract for every 100 shares of stock that you own, which creates a 2.5% hedge and lowers your cost basis by that same amount.  Also, if NKE would happen to trade above the strike price of 70 at expiration (October 18), you’ll make another $1, but the profits would be capped from that point and higher.

This strategy would be ideal for some friction around the fiscal policy and debt ceiling negotiations, but nothing too rancorous.  The idea is to collect some income and provide a modest buffer for your capital investment in NKE.
 

Let’s say that you think that there is a real possibility that things could get really messy in Washington and that we could potentially be headed down a road similar to the summer of 2011.  Partisan gridlock nearly prompted a technical sovereign default which caused massive volatility swings in the stock market.

Of course, a covered call strategy might not be a strong enough hedge if your range of expectations includes that potential scenario.

So, what you could also consider is a stock replacement style strategy to protect you over the next several weeks and see how the dust settles as Washington plays out the debt ceiling issue.

Looking back at the same NKE stock position, you’ll want to SELL your stock and BUY the NKE October 70 Calls.  As I mentioned earlier, with the stock trading around 69, the calls can be bought for 1.70.

You’ll want to buy 1 call contract for every 100 shares of stock that you sell.

So let’s say you owned 100 shares of NKE.  The stock sale will generate $6900 in cash proceeds, while you'd be spending $170 to buy the Call contract.

This strategy pays off if you do get a big move from the upcoming event catalyst.  If the stock tanks, say to around 60 and a level near the 200-day moving average, well then it’s a huge win as you lost 1.70 on the call versus 9 points otherwise by simply holding the stock position.  And remember, you still have $6730 in cash so you can re buy the same 100 shares now for $6,000.

And let’s say that Washington somehow has a Kumbaya moment and strikes a grand bargain and lifts the debt ceiling to boot.

Well, that could trigger a massive rally and, even though you sold your stock, you own the Oct 70 Call which gives you the right to buy your 100 shares back and capture all the unlimited upside potential above 70 per share.

Washington should be quite entertaining over the next couple of weeks, but it could also be a frustrating and fearful time for investors.  Having a game plan for your investments is always high on the list, and these two strategies can come in particularly handy during a period that’s known to go hand in hand with eleventh hour deal making and plenty of volatility.

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