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How to Trade A Stall in Fiscal Cliff Negotiations

 November 08, 2012 12:53 PM

The emerging post-election consensus is that the fiscal cliff is more likely to be addressed without roiling markets. President Obama, the theory goes, is stronger politically than he was in 2011, and Speaker Boehner also has more control over the Tea Party wing of the Republican party. The new power dynamic should make it easier for moderates to find a palatable mix of revenue increases and spending cuts.

This morning, John Carney mentioned an alternative view:

The confidence people have in a "kick the can" avoidance of fiscal cliff is likely misplaced, in my view. This creates trade opportunities.

The election, he thinks, was a victory for more radical elements on both sides, and a quick fiscal solution is less likely given that the current House makeup is more ideological than the body that initially voted against TARP in 2008. This raises the odds that both sides will dig in their heels initially, since the political risk of looking weak, especially for House Republicans facing midterm elections, would be greater than the economic damage caused by stalled negotiations. Joe Weisenthal wondered how people might trade this scenario.

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VIX futures term structure. Source: CFE, Vixcentral

If you think that the House will only adopt a workable bargaining position after a strong nudge from panicking markets – like it required in 2008 and 2011 – then one way to position yourself would be to buy near term VIX futures. The big advantage of a position in a pure volatility product here, as opposed to shorting the S&P 500 or even buying puts on SPX, is that volatility-linked products are independent from the level of stock prices. For example, if stocks rally over the next several weeks but implied volatility remains relatively unchanged during the negotiations, a VIX futures position would avoid the losses associated with being short stocks.

The idea would be to buy the January VIX contract (or shares of the VXX ETN) if it looks like the December 31st deadline might not be met, and then sell the position after a rally of several points in short-term implied volatility, or once the futures term structure moves into backwardation. Since even this scenario calls for an eventual budget resolution, experienced traders could sell the March or April futures twice against each January contract purchased to focus the position even more on changes in short term expectations.

We'll have more on this scenario in our weekly newsletter updates.



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