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Default & Downgrade Doom: Options Traders Preparing for the Worst Says Najarian

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Until yesterday, it was easy to dismiss the seemingly endless buffoonery masquerading as a "debate" regarding the debt ceiling by pointing to the markets. "We can't be in any trouble," notes Jon Najarian, the co-founder of OptionMonster.com, paraphrasing the complacency crowd "look at the bonds." But real traders don't care where we are now; they just want to know where it's going. In that respect, the smart money is betting the going is about to get very tough indeed.

Najarian's firm sifts through options volume and pricing to gauge how players in the pits are positioning themselves. When volume and volatility move higher in lockstep, it's a good indicator of traders' outlook. As the debt debate drags on with no end in sight, traders are wagering, or at least hedging long positions to reflect the idea that volatility is going higher. Such movements are somewhat par for the course in stocks, but 30-year U.S. bonds "shouldn't" be uncertain investments. Yet despite America's presumably risk-free status, the volume on the 30-year has spiked from the single-digits to nearly 13, a type of move not seen since the 2008 financial crisis.

An explanation isn't required to make a buy or sell order, so the specifics of what's driving the negatives bets aren't clear. A default is a fake threat. Politicians may act like imbeciles, but their survival instincts wouldn't allow them to commit professional suicide by stopping payments to soldiers and withholding Social Security checks. We aren't Greece -- at least not yet.

If not default, a downgrade of U.S. debt by the ratings agencies is the most likely driver of fear. Najarian feels it's more of a long-shot than the rhetoric and threats from S&P and Moody's would suggest. The agencies "don't have the guts and they're getting a lot of pressure," Najarian says. "I'm hearing they're being told they're not going to be doing business if they go ahead and downgrade."

Among other ways the government could "exert influence" is removing ratings provisions in government debt entirely. The government could also start reviewing the agencies' contention that their ratings are simply opinions protected by the First Amendment.

So if it's not a downgrade or a default justifying traders' huge bets on a volatility spike between now and the end of August, what is it? In this case the scariest monster of all just might be reality. The possibility that the world may be forced to acknowledge that the United States isn't the safe haven it once was could be a wildly unpleasant shock to the entire financial system: as in bonds down, yields higher, stocks abused, and tsunami size ripples up and down the entire economy.

"We're paying attention to something that's been a long-term problem," says Najarian. No further explanation is really needed.

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