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By: Costas Bocelli — October 3, 2013

Don't Let the Government Shut YOU Down!

It’s official.  We’re now in overtime.

With Congress unable to reach an agreement on a new spending bill by the Monday evening deadline, the government has been forced into a partial shutdown as the game clock expired on the 2013 fiscal year.

But that hasn’t stopped the political football from being tossed back and forth between the two houses of Congress.  They’re racking up plenty of yards, but yielding no touchdowns.

We’re now into the third day of the shutdown, and the Republicans and Democrats continue to remain deadlocked at midfield as they battle over the funding of the President’s health care law.

For now, many of the government’s routine day-to-day operations have been disrupted, which includes the furlough of 800,000 government employees.  The longer it’s allowed to continue, the worse it’ll get.

And we’ve already seen the direct impact on market volatility and investor fear in just this past week alone.  If you recall from last week’s Tycoon Report, 2 Ways to Hedge 11th Hour Volatility, we flashed a chart of the CBOE volatility index (VIX).

At the time, the reading was just under 14, which suggested that investors were becoming too complacent ahead of the fiscal deadline.

But on Monday, the VIX spiked above 17, which was the highest reading since the market lows in late-August.

Tuesday produced a market rally which eased the VIX back.  But yesterday’s whippy session saw the indicator back on the rise and nearing 17 again.

Fear is creeping back into the markets

As the political gridlock intensifies, President Obama finally seems ready to jump in and play referee.  Last evening, he summoned the top four Congressional leaders to the White House to discuss the spending bill impasse and the need to raise the debt ceiling.

Missing the eleventh hour deadline on a budget deadline is one matter, but if Congress continues the same charade in managing the debt ceiling issue, the VIX could quickly explode to 30 or higher.

The Treasury Secretary has alerted Congress that it’s using the remaining extraordinary measures to avert hitting the debt ceiling and, nevertheless, still projects no later than October 17 as the date the government will run out of cash and be unable to meet all its obligations.

The next couple of weeks are indeed going to be loaded with uncertainty.  Higher volatility and expanded trading ranges seem to be in the forecast.

Last week’s article also covered a couple of hedging strategies that could help your existing long stock positions to weather the storm.

But what about those investors who want to put new money to work, but are stunned and confused from all the uncertainty and political brinkmanship that Washington is creating?

The Fiscal Cliff negotiations at the end of last year were a harrowing time for investors and forced many to sit idle on the sidelines.  But an eleventh hour deal was eventually forged and a massive rally shot stocks nearly 5% higher in just two trading days.

Making matters worse was that many of those investors were left behind at the station as the bull train zoomed away.

That’s what happens when investors become most fearful and defensive.  Some of the biggest rallies in the market’s history revolve around events loaded with high anxiety.

Take for instance the latest sentiment survey from the American Association of Individual Investors.  The poll takes the temperature of the retail investor on how they feel about the stock market over the medium-term.

Currently 36.1% are bullish while 30.6% are bearish.  Those readings are not very extreme, but what’s most telling is that 33.6% are neutral.

That’s right, over a third of the respondents have a clouded view and offer little conviction either way.  That’s a great deal of investors that are signaling a high degree of uncertainty and, as a result, are sidelined and over-weighted in cash or other defensive securities.

Do you also belong in the neutral category?  Are you bullish on the stock market longer-term, but remain hesitant because of all the fiscal uncertainty created by Washington?

Would you be comfortable potentially owning the stock market at a discount while capturing unlimited upside potential, right now?

And would like to position the investment without outlaying additional capital other than the obligation to own the stock market at the discounted price?

Well if you answered YES to all of those questions, then the answer may be an options strategy called a Bullish Risk-Reversal.

How to get long the market without chasing it:

A Risk Reversal simply entails the purchase of an out-of-the-money Call option while simultaneously selling an out-of-the-money Put option.  It’s done in an equal ratio and uses the same expiration date.

The idea is to capture unlimited upside potential above the strike price of the Call option that you purchase and finance it by the sale of the Put option.

If structured properly, the trade can be done for minimal cash outlay or even a credit back to you.

There is of course risk to the trade, and it’s similar to simply being a typical buy and hold investor.  Options are a leveraged security and, as long as you position size accordingly, the risk is reduced to that of a buy and hold strategy or even less.

Let’s run through a timely example and show you how it works...

The S&P 500 has pulled back from its recent highs and is now testing technical support along the 50-day moving average.  You have money that you want to invest, but you are not as confident as you would like to be because of all the uncertainty surrounding the budget and debt ceiling debate.

You are also anxious that you may miss out on a massive rally if you stay sidelined in cash.  Every dip has been a buying opportunity and you want to ensure some way that you can participate while being respectful of accepting reasonable risk.

That said, you are comfortable owning a long stock position at a specified discounted price that’s known in advance.

If that description fits your investment goals, then the Risk Reversal option strategy may be suitable for you.

The SPDR S&P 500 ETF (SPY) is an exchange traded fund that tracks the performance in the S&P 500 index.  If I were an investor that was considering purchasing 100 shares of SPY, I could instead...

Buy One SPY (October, 25 2013) 172 strike Call for 0.95 ($95 per contract)

Sell One SPY (October, 25 2013) 163 strike Put for 0.97 ($97 per contract)

The structure actually nets me a $2 credit (ignoring commissions).

With SPY trading 169.18, the 172 strike is less than 2% away and close to the previous record highs achieved in mid-September.  If the fiscal issues get resolved and a rip roaring rally sends the market to new highs, the position will act just like a 100 share SPY position above 172.

If we see further downside pressure, the position could obligate you to buy the SPY at 163, which would represent a 3.5% discount from yesterday’s close.  That also happens to be another important area of support around the late-August lows.

If the SPY should continue wallowing around between those strikes by expiration, October 25, 2013, then both options would expire out of the money and leave you with no position or any lost capital from creating the position since it was done for nearly Zero (.02 credit).

SPY 172/163 Oct 25, 2013 bullish Risk Reversal...

The biggest benefit options give investors are that they really give you options!

Over the past two weeks, we discussed three simple strategies that can help you easily navigate difficult times in the market like the uncertainty surrounding the resolution of the budget and debt ceiling issues.

If only there was a strategy to fix the politicians in Washington, then we’d all be in a much better place!

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