The risk of a sizable market drop if Congress refuses to raise the debt ceiling is great enough that a hedge position is justified. 
There are two areas of risk if the struggle within the GOP continues into late October and the Treasury runs out of borrowing capacity. The first risk is that of a fiscal guillotine, a swift and devastating cut in government spending that has been estimated at 32% of the federal budget. The deflationary effects of missed payments to Social Security, Medicare, and unemployment insurance recipients would be gradual, but the effect on consumer sentiment should be more sudden. The second risk is that of a debt default, of turning the one risk-free asset the world has left into just another set of risky paper. The effects are hard to predict, but for a good look at some of the details and risks, see this report from the Bipartisan Policy Center.
The Treasury Department has estimated that its debt limit would be reached “no later than”Thursday, October 17. The BPC report linked above pegged the “X date” – the day when Treasury wouldn’t have enough cash on hand to meet its daily obligations – in a range from October 18 to November 5.
Projected range of the “X” date. Source: Bipartisan Policy Center
From the perspective of equity portfolio hedgers, this is the time to be adding protection, not a day or a week before the limit is reached. By then, assuming no political progress has been made, markets will already have started to price in a large risk premium, and hedgers who are late to the table will probably overpay for protection: overpay, that is, for protection that every reasonable person hopes will prove unnecessary. Expected events with known dates (or narrow date ranges) can be treated somewhat like corporate earnings reports: option implied volatility will rise ahead of the event as demand pushes option prices higher, and then after the event, implied volatility will drop even if the asset affected sees a large price change.
Sometimes it is possible to buy options well ahead of earnings and to see the increase in implied volatility offset most or all of the time decay associated with holding the options. We will be taking a similar approach here: entering a position well ahead of t he expected event because we don’t expect to the net cost (time decay less increase in IV) to be substantial.
The attached risk dashboard gives us a quantitative look at where key risk variables are right now, relative to the past year:
Two month implied volatility momentum, one month realized volatility of implied volatility, and implied vol skew are all high, and the latter two are well beyond their top quartile bounds. Riskperceptions haven’t filtered into nominal IV readings yet, as both the CBOE Volatility Index(VIX) and one-year SPDR S&P 500 ETF (SPY) implied vol are below one year median values. Those readings should rise this week, though, with a government shutdown possible and Sunday night S&P 500 futures down eleven points.What these risk readings tell us is that it is still a favorable time to get long volatility. Equity index options are not cheap (15% one month implied vol vs. trailing SPX realized vol of 9.4%), but if you expect more market turmoil in the weeks ahead, SPX puts and VIX calls are attractive. Note that VIX options were priced above 90% implied vol at the beginning of September, and theCBOE VIX Volatility Index (VVIX) index closed below 75 on Friday. October VIX options expire before the state Treasury debt limit date, and then there is the unknown range within which the Treasury would run out of cash, so I think the best approach will be to trade November contracts.I want to watch the market action early this week and see what happens with the shutdown story, and then we will price a debt ceiling VIX hedge.
