US shutdown: Default seems unthinkable but investors have options

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Investors who behave conventionally are likely to get burned if the political standoff over the federal budget. Reuters Investors who behave conventionally are likely to get burned if the political standoff over the federal budget. Reuters
SummaryUS stocks retreated for a second straight day as the shutdown dragged on and the dollar weakened.

Investors who behave conventionally are likely to get burned if the political standoff over the federal budget and the debt ceiling ends up forcing the United States to default.

But portfolio managers and strategists say that if investors put their trading hats on, they may be able to protect themselves and even possibly come out ahead.

"The next two weeks could cause a lot of pain in many portfolios," said Mark Yusko, CEO and chief investment officer at Morgan Creek Capital Management, LLC, in New York.

One of the few things pros like Yusko agree on when it comes to the partial U.S. government shutdown that began this week and the possible failure to raise the government's legal borrowing limit by Oct. 17 is that market turbulence is likely to rise.

US stocks retreated for a second straight day on Thursday as the shutdown dragged on and the dollar weakened broadly. While the selling has been orderly so far, investors see anxiety rising if the weekend arrives without any sign of a political deal.

One way to take advantage of that, portfolio managers say, is to simply bet on more volatile trading rather than try to navigate the ups and downs of the stock or bond markets.

The CBOE Volatility Index, the world's best-known fear gauge, hovered around 17 on Thursday, roughly a two-month high but still a far cry from 48, where it peaked in 2011, the last time Congress threatened not to raise the debt ceiling.

"Even a legitimate threat of a default will send volatility exploding - even to the 30s," Yusko said. "You can make a lot of money in a short period of time."

Yusko said investors can get exposure via the unleveraged iPath S&P 500 VIX, also known as the VXX, or the leveraged VelocityShares 2x VIX, or the TVIX.

For those who think it could approach 2011 levels again, snapping up a buy option now looks like a bargain and could be a nice way to hedge against losses elsewhere.

The same goes for buying options to sell the S&P 500 index, said Dan Greenhaus, chief global strategist at BTIG.

"The environments are certainly different, but given the similarities on the legislative side of things, we wonder why volatility hasn't already begun moving higher," he said.

Douglas Peebles, chief investment officer for fixed income at Alliance Bernstein, added: "Don't short volatility. Because all roads lead to it. There is going to be less liquidity and

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