The Debt-Ceiling Standoff Will Create Panic in the Stock Market. How to Profit From It.

Text size

The volatility opera has begun.

Rather than panicking that the U.S. government may run out of money in early June, do something more than watch TV and complain about America’s poisoned politics.

Long-term investors could monetize these increasingly widespread fears that America might default on its debts for the first time ever by using options to enhance positions in blue-chip stocks.

The cash-secured put strategy, as it is called, enables investors to position to ultimately buy stocks at lower prices while collecting premiums. It entails depositing money into a brokerage account, which is then used to securitize the sale of put options, which give holders the right to sell an underlying asset at a set price within a specific period.

When equities decline—especially in response to events beyond the market’s control—investors usually overpay to hedge their stocks. Puts increase in value when stock prices decline, which makes them popular in panics. The fear of a debt default should make many investors eager to buy protection insensitive to put prices.

If Congress fails to raise the debt ceiling and prompts a debt default, stock prices will almost certainly collapse. The U.S. government is the nation’s largest employer, and a failure to pay employees could spark a recession.

Because there are so many moving parts to the debt-ceiling crisis, picking a jumping-in point is tricky. Investors should use the

Cboe Volatility Index,
or VIX, to time their moves. The so-called fear gauge was recently around 18. During the past 52 weeks, the VIX has ranged from 15.53 to 35.48.

Be prepared to sell puts that expire in less than three months at different strike prices should VIX spike to various levels, such as 25, 30, 35, and so forth. The goal is to incrementally buy blue-chip stocks at lower prices, while taking advantage of the waves of fear that should hit the market if Congress seems unable to agree on permitting the government to borrow more money.

Consider using the

ProShares S&P 500 Dividend Aristocrats
exchange-traded fund (ticker: NOBL) as a blue-chip proxy. With the ETF around $92, the July $85 put is around 80 cents. Selling the put positions investors to buy the ETF at an effective price of $84.20. The ETF has ranged from $79.09 to $95.70 during the past 52 weeks.

Only use this approach if you can afford to warehouse the ETFs, and collect the dividends, for at least three to five years. Why the long holding period? All crises ultimately end—even recessions.

The tension in the market is provocative. If a major stock seller emerges, the Street will likely freak out that someone has good information on the Washington negotiations, and that, too, could spark a big decline.

But any stock decline will almost certainly be a temporary reaction. Stocks may even benefit from a default as investors regain their senses and realize U.S. stocks are among the world’s best stores of value.

This thesis isn’t as outlandish as it seems. America’s political scene is arguably the most acrimonious since the Civil War era. In comparison, corporate America offers a generally sane counterbalance.

Consider the gravitas of, say, Warren Buffett or Jamie Dimon, as opposed to many Democratic and Republican leaders. Who is trusted more to make sound decisions?

Of course, equities are arguably riskier than U.S. Treasury bonds, which are the world’s reserve currency, but equity risk can be hedged away with options. That could create a feedback loop that makes puts even more expensive.

Steven M. Sears is the president and chief operating officer of Options Solutions, a specialized asset-management firm. Neither he nor the firm has a position in the options or underlying securities mentioned in this column.

Email: [email protected]