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How to Play Debt Ceiling Volatility

As we dive into the New Year, the heated debate over the fiscal cliff has come to an end, but an even more important one is about to occur… the debt ceiling. If you thought the volatility we saw during the peak of the fiscal cliff debate was impressive, it most likely will pale in comparison to what awaits us on the horizon.

During the theatrics surrounding the fiscal cliff, we saw the VIX cross the 20 mark, and at the time it seemed like we were in a highly volatile market. Headlines started to appear everywhere regarding the high volatility, but as I pointed out at the time, historically speaking it was not really that high.

In that article I mentioned the level of volatility that we saw during the last debt ceiling debate, a time in which volatility inched above 45 and the market tanked. There is absolutely no reason to believe we will see anything different this time around, and it will make the reading of 20 we saw last month look small.

The reason is that the fiscal cliff debate featured headline discussing how the nation would fall into a recession had a deal not been reached. As bad as that would have been, the headlines were not nearly as terrifying as what we are about to see regarding the debt ceiling. Both political parties are going to try to make a stand, and we will hear reports of Social Security checks will not go out, military veterans will be in jeopardy of not receiving their checks… it will lead to the same sort of panic we saw during the 2011 debt ceiling debate which devastated stocks amid a cloud of high volatility.

If you look back at a market chart during the summer of 2011, you can easily spot where the debt ceiling debate took place. The drop was substantial, but what is really important to note is that the losses were made back pretty quickly. It took a couple of months for investors to recoup their losses, but generally speaking the drop was just a blip on the radar.

I can expect the same this time around. Both political parties will try to flex their muscles, and as a result I believe a deal will not be reached until the last possible minute, resulting in a lot of volatility and most likely a short lived sell off in the markets.

If you think history will repeat itself, there are a couple different ways that you can try to profit from the ongoing debate over the debt ceiling. You can either try to play the selling that will most likely occur in February, or try to play that bounce that is expected after a last minute deal is reached.

In order to play the downside, you would simply need to buy some puts on the broad market. You can short the S&P 500 by buying some February puts on SPY. SPY will move roughly in tune with the S&P 500, so you will start to make a profit once the selling starts.

A second way to approach the situation is to sit back and wait for the selling to reach its peak. You can expect a last minute deal, so there is no rush to take the bullish approach. Once we get within a couple days from the deadline you can move in and long the market in anticipation of a rally. Based on the last time we saw this situation play itself out it took about four months to see the losses erased, so you could look at buying calls on SPY which are about six months out.

Below is a video to give you a better understanding of volatility:

Michael Fowlkes

Michael Fowlkes is a financial writer who has been with the Fresh Brewed Media family since 2004. Over the course of his tenure with Fresh Brewed Media, he has worn many hats, including portfolio manager, options analyst, and writer. Michael received his undergraduate degree from Virginia Tech in Accounting and got his start in finance working as a stock trader for six years at Chase Investment Counsel in Charlottesville, Va.