A strategy idea for options trading investors.

Washington, my friends, is slowly but surely losing its mind. You see I live here, so I see it and feel it and fear it with more intensity every day. The pace of lunacy is quickening. And with this growing insanity there is money to be made.

The two political parties cannot agree on raising the debt ceiling limit, due to be hit on August 2. The first Treasury bond auction of thirty day notes is next week —  11:30 a.m. on Wednesday July 6. Bond buyers, for the first time in history, will be uncertain when they will get repaid.

Wall Street is not focused on this auction — they are focused on what will happen on August 2 if the ceiling on US debt is not lifted and the US Treasury runs out of cash to pay bills and bond holders. They are ignoring warnings by the bond ratings agencies about US debt and the possibility a credit downgrade could come before that August 2 date. And, Washington being what it is, all the players are assuming they have until midnight August 1 to cut a deal – with the assumption being the Democrats will go for more deficit reduction and the Republicans will agree to lift the debt ceiling.

Think about it — as early as next week the markets cold feel the impact of the debt ceiling crisis. They may, they may not.

First, what is so bad about a credit downgrade?

• On the surface the biggest impact will be on interest rates. The analysts I follow figure $100 billion or more in increased borrowing costs per annum not to mention the haircut bond holders will take on the underlying value of their bonds. I guess this is a flaw in trying to lower the deficit by playing brinksmanship with the debt ceiling, eh?
• The biggest potential impact is on the world financial system. Trillions of dollars of derivatives, many legal contracts, even pools of money to pay insurance claims, must be supported by AAA rated debt. Change the rating and counterparties will have to post many billions more in collateral. Central banks will again be called to the rescue if counterparties see liquidity dry up. Shades of the liquidity crunch after the Lehman bankruptcy.

The distrust of Treasuries has already started. The cost of insuring US Treasury debt through the purchase of credit default swaps has risen 700% in the past year.

At present Wall Street finds a default unthinkable. Politicians are using this attitude to push the country and the world financial system to the brink. One totally mad politician now running for president believes the US can hit the debt ceiling, run out of cash for all bills and just pay bondholders first. As if the credit ratings agencies and credit markets and all financial counterparties to any risk around the world would not react. It is this kind of lunatic thinking, driven by politics and not problem solving, that makes July a time to make money if and when the crisis unfolds.

There are three sets of plays:

• Low risk trade, or The Flight to Safety: Since Treasuries are no longer a total safe haven, there will be a flight to safety, possibly through exchange-traded funds. This means precious metals – the SPDR Gold (NYSE: GLD) and iShares Silver Trust (NYSE: SLV).
• More Low Risk: This also means other currencies — the ETF for the yen is the CurrencyShares Japanese Yen (NYSE: FXY). Given market risk, rather than buy call options on these ETFs I would sell puts. Sell them for August and out-of-the-money.
• High Risk Trade, or Short Treasuries: Treasuries are going to take a hit and not only from the evolving crisis. The Fed is no longer expanding its balance sheet with purchases of Treasury bills, so that price support is over. Look at buying calls on the ProShares UltraShort 20+ Year Treasury (NYSE: TBT), the double inverse ETF for 20-year Treasuries. Look at OTM call options, one or two months out.

I still find it hard to believe the nation has been placed on this path. Just make sure if there is a real crisis, you do not have regrets about missed profits because of the road not taken.

Michael Shulman uses simple trading tactics to make solid, profitable investments in falling stocks in his Short-Side Trader service.