The U.S. debt deadline of August 2nd has been on most traders' minds for quite some time now. At first it didn't seem like a big deal, as the debt ceiling has been raised lockstep with U.S. debt levels in the past, and most market participants gave lawmakers the benefit of the doubt that they would again find a solution in time and the event wouldn't have a big market impact. However, with each passing day absent a deal, the potential for a market-moving missed deadline grows. Although most still don't expect that the deadline would be simply missed (most expect an 11th hour deal or some sort of temporary resolution), the potential for a downgrade of the U.S. debt remains even if a deal were to get done.

At this point, nobody knows how things will play out over the coming week, and given the many variables and political uncertainty, we won't try to predict the outcome. However, we do know that the market has been relatively calm up until this week, despite the nearing deadline. We've seen the VIX Volatility Index begin to move up this week, indicating increasing volatility expectations, as the S&P 500 declined 1.8% so far on the week. Nobody knows the extent to which the market will react to a failure to meet that deadline or a downgrade of the U.S. debt, but we would expect increased volatility and fear as that deadline approaches in the absence of an agreement.

Considering this uncertainty, we thought it would be worthwhile to discuss a few insurance strategies for those who would like to buy a little protection against the possibility of a failed deal. We're looking at two strategies: 1. Long S&P Puts and 2. Long Gold calls. See details below.

1. Long S&P (SPY) puts: One could purchase near-term (Aug) puts on the SPY (S&P SPDR) ETF to protect long positions against a near-term move to the downside. The SPY Aug 132 puts are currently offered at $2.55, and would benefit from a move to the downside in the market. These puts would see an expiration breakeven point of $129.45 (-2% from current levels), but could experience profits prior to expiration on a smaller move to the downside. See P&L chart below.

2. Long Gold (GLD) calls: Although gold has already seen a flight-to-safety bid as a result of the U.S. and European debt situations, it could see further upside on negative U.S. news with regard to the debt ceiling and/or a ratings downgrade. We would use GLD calls or call spreads to position for upside in gold in reaction to such a negative outcome. Gains from the GLD position could offset losses in other long-equity positions. As an example, one could purchase the August $160 GLD calls for $2.13. These calls would benefit from an upside move in gold prices, and would see an expiration breakeven point of $162.13 (+2.4% from current levels), but could experience profits prior to expiration on a smaller move to the upside. See P&L chart below.

We like the idea of using options to protect against this uncertain event since they provide leverage and only require a small percentage of capital to provide some protection on a portfolio. While the VIX will rise on increased volatility, we're staying away from trading options on it and don't particularly like the bang-for-buck that's available from the VXX ETF.

We'd acknowledge that these hedges could have been put on at better prices days ago, but things didn't look as bad at that time. Finally, we'd emphasize that we're looking this as a hedge against an unknown event, rather than speculating on an outcome.

-Chris Borgmeyer, CFA