By Doris Frankel and Angela Moon
(Reuters) - With the U.S. government in Washington partially shut down, some options investors are starting to pay more for protection against market turmoil on worries that the current budget stalemate could lead to something more catastrophic - a default.
So far Wall Street has taken the back-and-forth in stride. The S&P 500 index is down 1.3 percent for the week, but still up 18 percent for the year, and numerous strategists have said the eventual resolution of Washington's legislate battles will provide a buying opportunity.
The effect of this so far has been to lift volatility indexes, but slowly, and from extremely low readings to levels still associated with relative calm in markets.
That's not to say all is quiet. The CBOE Volatility Index or VIX (^VIX), widely known as Wall Street's fear gauge, has been moving up, and heavy trading in VIX options of late suggests some investors taking precautions. The so-called fear gauge this week topped the 18 level for the first time in three months.
"Certainly we have seen the bloom come off the rose for the broad market over the past few weeks as the government shutdown approached," said Brent Archer, options analyst at options research firm InvestorsObserver.com, in Charlottesville, Virginia.
The deadline for raising the debt ceiling is October 17, the last day that the Treasury Department estimates the federal government is certain to have enough money to pay all its bills.
During the debt ceiling crisis in 2011, resulting in the first-ever downgrade of the U.S. credit rating, the VIX surged as high as 48.
The VIX, a 30-day forecast of stock market volatility measured using a strip of near-term S&P 500 options, rose to 16.73 on Friday, from 13.12 on September 20, a sign of increased worry, though the current level is still considered low.
VIX options, priced off of VIX futures, have been very active. Volume on Thursday was 2.4 times greater than the recent daily average, according to options analytics firm Trade Alert.
Heavy buying activity on Thursday was seen in October and November VIX out-of-the money call options - contracts that are far from the current level - with heavy open interest additions in November contracts.
"This suggests traders are feeling the need to be protected through mid-November and implies that the market expects negotiations in Washington over the government shutdown and debt ceiling will be long and drawn out," said Matt Franz, investment advisor representative at Stutland Volatility Group.
One way to measure the cost of hedging with VIX options is to look at the VVIX Index (.VVIX), the volatility index for VIX options. The VVIX on Thursday rose 9.4 percent to 93.79 after hitting an intraday peak of 105.33, highest since April.
"This suggests that option traders are paying up for protection at a level that they have not done since the spring," said Jared Woodard, a principal of Condor Options, a research and advisory firm in Forest, Virginia. The VVIX was off 5.01 percent to 89.09 on Friday afternoon.
If the VVIX tops a two-year high of 117.44 reached in May 2012, it could be a signal that the market will react abruptly to the political stand-off, said Ophir Gottlieb, managing director of options analytics firm Livevol.
FUTURES CURVE FLATTENS OUT
The shape of the VIX futures curve, a graphical representation of the prices of all of the contracts from October to June 2014, is fairly flat, another bearish signal for stocks, strategists said. The spot VIX has closed above the front-month futures contract every day this week, JPMorgan Chase U.S. equity derivatives strategists said in a Friday report.
"Historically, 95 percent of large VIX spikes were preceded by several days of front-end inversion, but the spikes typically started from a higher VIX level," they wrote.
The two VIX futures contracts with the shortest maturities - those expiring in October and November - have traded lately at a discount to the spot VIX index. However, those front month contracts are rising faster than back month VIX futures, leading to a flattening to the VIX term structure. That suggests more worry about the very near-term than for first half of 2014, when the budget battle would presumably be over.
"If the term structure were to flatten completely and turn negative, that would be quite bearish," said Lawrence McMillan, president of McMillan Analysis Corp, in a report on Friday.
SUDDEN CRASH IN VOLATILITY
Typically, a politically driven crisis is only a temporary boon for volatility.
"As soon as the crisis is resolved, volatility tends to come (down) very quickly. There is no telling when that will be, so we have been long front month VIX futures as protection," Stutland's Franz said.
In order to catch a sudden crash in volatility, Stutland added out-of-the-money put spreads on the iPath S&P 500 VIX Short-Term Futures exchange-traded note (VXX.P). The ETN is based on the two front-month VIX futures contracts, which usually carry a premium to the value of the VIX. The ETN closed up 3.6 percent at $15.17 on Thursday. This play benefits if volatility declines in the next two months.
Some traders this week have also been buying puts on the Financial Select Sector SPDR fund (XLF) and the SPDR S&P 500 Trust (SPY), two popular exchange-traded funds, to protect their portfolios or take a bearish stance.
Archer said his firm's strategy using out-of-the-money put options builds plenty of downside protection into their bullish positions on large-cap stocks with strong fundamentals.
"For the time being, I think traders are not betting on a huge upswing but have not yet panicked either," he said.
(Reporting by Doris Frankel; Editing by Nick Zieminski)