You may be like many Americans of late, wondering what will become of the budget stalemate in Washington D.C. “The shutdown is bad enough, but what will happen with the Debt Ceiling? And how can I make money with all of this uncertainty?” you ask. Those are good questions. Even for the most seasoned investors, it is almost impossible to know whether or not Congress will act like responsible adults and actually do their jobs. Thus it is impossible to know which way to play the market. Will it go up, or will it go down?
That will completely depend on whether or not we default on our debts for the first time in modern history. So knowing which way the market will move (and how to play it) is not going to happen. You could make a bet in either direction, and who knows if you will be right? So what should you do? Where can we make money?
Playing the Fear Factor:
If you want to make money in this situation, you can do what many pros are doing and invest in one trend that is absolute: FEAR. It is precisely because most people can’t predict what the markets will do that fear is rising. While I can’t pick a direction for the Dow Jones or the S & P 500, I can tell you that one commodity that is likely to climb is fear. The closer our country comes to the October 17 debt ceiling deadline (and the possibility of default) the more fear will be a very real factor in the markets. So how can we make money from fear?
The short and sweet of it is, we play the “Fear Index,” otherwise known as the VIX. Without going into massive amounts of detail, the VIX is an index that measures fear in the markets. When traders become afraid, there is more volatility (bigger moves up, and stronger moves down). That increase in volatility is measured by the VIX. As fear grows, the volatility rises, and the VIX moves up. At the time of this writing, the VIX (which you can see by typing VIX into a financial website or your brokerage account) was at 19. It has been steadily rising as the dysfunction in Washington pointed to a probable shutdown.
Assuming that the Congress is unable to put the country first, and actually work out a solution until the last minute (if at all), the VIX is likely to keep rising, as the nervousness and fear in the markets increase. The closer we get to the deadline without a deal, the more nervous global financial markets will get, and the higher the VIX will climb. We can play that move for very little financial risk.
Trading on Fear:
As I said, I can’t tell you which way the market will move. However, I can tell you that it is very likely that the level of fear will continue to rise. We can trade that rise through the VIX. In today’s markets, there are options available for almost everything. This includes the VIX. You can bet on the direction of this index through options.
At the time of this writing, the VIX closed today at 19.41. We could buy a call option that will play the upward move that is likely. As of this moment, a December 19.00 call option trades at $2.45. That means (to review option basics) that for $245 ($2.45 x 100 shares — option contracts always control 100 shares) we could capture the upward movement of the VIX above 19 until December. So if the VIX climbs to 25 (a point far below the highs it reached in the 2011 Debt Ceiling fight) we could capture that movement. Most of that 5.59 point move would be captured by the call option. The option that we purchased for $2.45 per share, could easily rise to $6 per share resulting in a gain of $355 per contract. (That would be a return of more than 100 percent that could be made by playing a likely rise in fear.)
Are there risks? Sure there are some. Washington could come to their senses. That would reduce fear and the call could lose value. But even if the House and the President become best friends and all the problems are solved, the most that you could lose is your initial investment of $2.45 per share (or $245 per contract) using the quotes from above.
As an investor with 20 years of experience, I think that is a pretty good bet. At the time of this writing, I do not have a position in any VIX options. However, I think I’ll be taking my own advice in the morning.
So while it will be very hard to know what direction the market may move over the next many days of political drama, it is very likely that the one thing that will rise is the fear level. And we can make money on the markets fear with the VIX.
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