Traders Hedge Bets as Budget Talks Turn to Bluster

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U.S. markets in the last few weeks have conveyed a strong sense of optimism over Washington's budget battle - perhaps a bit too much.

The benchmark S&P 500 index recently capped off its best two-day run in a month and the euro reached an 8-1/2-month peak against the dollar, largely on expectations that an agreement to avoid the "fiscal cliff" - $600 billion in automatic spending cuts and tax hikes set for early next year - is nearly at hand.

But at the risk of sounding like Ebenezer Scrooge, some investors fear a sudden run of bad news could snuff out the pre-holiday cheer and send stocks down. As a result, they are wading into the options market to hedge their bets and protect their profits.

"With all the uncertainty, we want exposure to sectors but we don't want to risk as much," said Michael Matousek, senior trader at U.S. Global Investors Inc, which manages about $3 billion. "We want to limit our positions because we don't know what will be impacted and by how much."

Republican Speaker of the House John Boehner, in a brief press conference on Wednesday, dared President Barack Obama to oppose Republican plans to cut taxes for all but those making $1 million or more in annual income.

(Read More: In New 'Cliff' Bid, Obama seeks $1.2 Trillion in Revenue)

After his remarks, both the S&P 500 and the industrials hit the day's lows.

Boehner's gambit, which followed another press conference where Obama suggested Republicans need to get over reflexive opposition of him, shows the two sides still have work to do to bridge their divide.

"It is very difficult to say if the optimism out there is warranted," said Alec Young, global equity strategist at S&P Equity Research in New York. "We don't know what's going on behind the scenes, and that makes it very difficult to account for all the uncertainty out there."

Playing It Safe

Some investors have started to limit exposure to stocks that have had a strong runup. A popular strategy is stock replacement, which involves selling shares outright and, instead, buying a call option - a bet the stock will keep rising - on those securities.

(Read More: Why Economy Could Slow Even With 'Fiscal Cliff' Deal)

This allows investors to take profits and also reduce risk, particularly if budget talks break down and the market sells off. But they retain the option to get in on the gains if things go well by exercising their call, or "buy" options.

"We have seen this strategy in eBay, , Juniper Networks, Coca-Cola and Starbucks, among others," said Phillip Saunders, an equity derivatives strategist at Topeka Capital Markets.

Another approach: covered calls, in which investors hang onto a position while simultaneously selling a call option on it to increase their income. In this case, if the asset falls in value, some of the losses are offset by the premiums collected on the unexercised call option.

It's a strategy that Michael Fredericks, who manages the BlackRock Multi-Asset Income Fund, has employed with high dividend-yielding U.S. stocks, which could suffer if no deal is reached and dividend taxes spike from 15 percent to as high as 40 percent for some earners.

"When you add the value of selling an options contract to the dividend payment some companies distribute, you end up with a really attractive value proposition," Fredericks said.

The benchmark S&P 500 is up nearly 15 percent this year, with three sectors - industrials, financials and consumer discretionary shares hitting 2012 highs. That has increased the desire to hedge. On Wednesday, put options - bets on a market decline - on the S&P were trading more than three times the average volume of the past five trading days.

"What this suggests is that people are buying options in the S&P 500 index in order to protect themselves in case of a selloff into year-end," said J.J. Kinahan, chief derivatives strategist at TD Ameritrade.

Tail Risk Narrows

Overall, volatility remains low as stock trading winds down for the year. The CBOE Volatility Index, Wall Street's "fear gauge," rose to 17.4 on Wednesday, spiking after Boehner's comments but still well below its long-term mean of 20.5.

The market slipped following Boehner's words, with the S&P ending down 0.76 percent, but the overall low volatility suggested investors believe the outlook remains positive.

"I definitely think there is some risk, though," said Douglas DePietro, head of trading at Evercore Partners in New York, adding that some investors were protecting themselvs by buying funds that bet on declines in the S&P 500.

Currency investors who fear a plunge over the "fiscal cliff", should consider selling currencies with strong U.S. links such as the Canadian dollar and Mexican peso against the Japanese yen, which usually rises when risk aversion spikes, said Steven Englander, who heads Citigroup's global G10 FX strategy.

He said some investors might be reluctant to hedge their bets now, after having been over-cautious in the past and missing out on the rally.

Unlike in early 2012, investors are no longer singularly focused on protecting against massive risks such as the 2008 market meltdown or the possible demise of the euro.

"Through much of this year, these....outcomes were central scenarios that investors pursued, and that in some cases weakened the returns that they got," Englander said.

But Michael Khouw, head of equity derivatives at CRT Capital Group in Stamford, Connecticut, said thin pre-holiday trade may be suppressing volatility somewhat.

"I don't think that the options markets are overly complacent," he said. "I would have expected option volume to drop off this year and it has not, and this is a reflection of the fact that market participants could expect a sharp move, up or down, in equities."