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Everyone seems to be talking about the looming fiscal cliff. If Congress doesn't get its act together in the next six weeks, the Bush tax cuts will expire (reducing everyone's spending ability) and the mandated cuts in military and other government spending will give the economy a double whammy.

The Congressional Budget Office, a non-partisan research group, and most economists predict that the United States will fall back into a recession if nothing is done to stop the fiscal cliff. The stock market as a whole (NYSEARCA:SPY) would surely suffer big time.

Some pundits are argued that the fiscal cliff might not be so bad, but my thoughts are more closely aligned to those expressed in a recent Seeking Alpha article - Fiscal Cliff: How Bad Would It Be?

While everyone in Congress seems to say they are willing to swallow the big C word ("compromise") and get something done to avoid the fiscal cliff, we have seen four years of talking with very little actual cooperative action. What are the odds that the Congressional tiger will suddenly change its stripes in the next few weeks?

What should you do to protect the tens (or maybe hundreds) of thousands of dollars in your investment account made up of your favorite stocks or mutual funds if the fiscal cliff becomes a reality? The potential loss is so great that some sort of insurance surely is in order, even if you have great faith in the politicians in Washington. I believe that a well-designed options portfolio can do the trick.

So far, in spite of last week's drop in the market, fear hasn't really raised its ugly head, at least quite yet. Let's see what happens as we wind down toward the end of the year. The "fear index" (VIX) is hanging out around 17.5, well below its mean average of 20.4. (As I write this, SPY is down slightly for the day and VIX has fallen over a full point, from about 18.5 to 17.5, suggesting that the conciliatory words from Congressional leaders are reassuring the market, at least so far.)

In the summer of 2011, when rumors of a European melt-down circulated, VIX shot up to 40, and VXX (the underlying I recommend using in the options portfolio), rose from about $20 to over $40. Clearly, there is a strong correlation between VIX and VXX. There is an equally strong inverse correlation between what the market does and VIX.

I have suggested using a combination of VXX option spreads to protect against a market crash - The Ultimate Hedge Against a Market Crash. The option strategy I created is admittedly a little complex. Many people have commented that it would be far simpler just to buy calls on VXX if it is so inversely correlated with the market.

Others have asked why you just don't buy puts on the market, presumably the S&P 500 tracking stock . Either of these choices would obviously work out if Congress fails to act and the fiscal cliff scenario causes havoc in the markets.

The flat-out purchase of either puts or calls carries one serious shortcoming, however. It is the same problem with any option purchase. If nothing much happens to the underlying (something which occurs in the real world most of the time), you stand to lose 100% of your investment. That never sounded like a very good investment idea to me.

The option strategy that I suggested is designed to overcome the essential shortcoming of just buying options. Most insurance - fire insurance, liability insurance, life insurance, or most fiscal cliff insurance - costs money. You have to shell out some premium money to cover the possibility that the calamity occurs.

The option strategy I set forth is designed to eke out a small gain each month even if the calamity does not come about. If that is indeed the case, it sort of like insurance without the insurance premiums. That seems like a better investment idea.

I can't agree with dismissing an investment strategy just because it is complicated to carry out. I believe that people should learn enough about the potential coverage that options can provide, and set up some fiscal cliff insurance on their own. If they don't want to spend the time it would require to learn all about options, they could subscribe to a newsletter such as TerrysTips.com and mirror the portfolio that I carry out there or have their broker place trades for them through their Auto-Trade program. (I call it the Crash Control portfolio).

When fear crept back into the market in the week of the presidential election (SPY fell 2.4%), the Crash Control portfolio gained 12%, proving that the strategy works when the market is weaker.

Here are the exact spreads that you would need to place in this portfolio in case you want to mirror it (it would require about $5000 to set up at a time when VXX is trading at $35.34):

BTO (buy to open) 10 VXX Jan-13 33 puts (VXX130119P33)
STO (sell to open) 20 VXX Dec-12 30 puts (VXX121222P30)
BTO 10 VXX Dec-12 27 puts (VXX121222P27) - buying a custom butterfly spread

This spread is designed to provide downside protection in case the market does not crash and instead, VXX drifts lower.

BTO 3 VXX Jan-13 33 puts (VXX130119P33)
STO 3 VXX Dec-12 33 puts (VXX121222P33) - buying a calendar spread

BTO 2 VXX Jan-13 35 calls (VXX130119C35)
STO 2 VXX Dec-12 35 calls (VXX121222C35) - buying a calendar spread

BTO 4 VXX Jan-13 38 calls (VXX130119C38)
STO 4 VXX Dec-12 38 calls (VXX121222C38) - buying a calendar spread

BTO 4 VXX Jan-13 41 calls (VXX130119C41)
STO 4 VXX Dec-12 41 calls (VXX121222C41) - buying a calendar spread

BTO 4 VXX Jan-13 39 calls (VXX130119C39)
STO 4 VXX Dec-12 45 calls (VXX121222C45) - buying a diagonal spread

BTO 4 VXX Jan-13 45 calls (VXX130119C45)
STO 4 VXX Nov-12 45 calls (VXX121117C45) - buying a calendar spread

BTO 1 VXX Jan-13 35 call (VXX130119C35)
STO 1 VXX Nov-12 35 call (VXX121117C35) - buying a calendar spread

BTO 1 VXX Jan-13 36 call (VXX130119C36)
STO 1 VXX Nov-12 36 call (VXX121117C36) - buying a calendar spread

These last three spreads are selling the November calls which expire this Friday. They are included to provide premium decay to make the whole portfolio theta positive (so it makes a small gain each day that nothing much happens). Once these November calls expire, assuming that the fiscal cliff has not been avoided by Congressional action, the 35 and 36 calls will be bought back and replaced by selling Weekly calls expiring 11/16/12 (at strikes $1 and $2 below the price of VXX at the time) but the 45 calls will be allowed to expire worthless and will not be replaced by selling Weekly calls.

I admit that this portfolio is complicated, a real hassle to set up and manage over time. However, I don't know of any simpler way of buying insurance protection against a fiscal cliff event or market crash, insurance protection that should make a small gain every month that the calamity does not occur.

If it were any easier, everybody would be doing it, and it would probably be traded so much that it would cease to exist (option premiums might be shaved away).

There are three likely ways that Congress will handle the fiscal cliff crisis:

  1. Agree to a compromise that will avoid the crisis.
  2. Kick the can down the line a few months for the next Congress to deal with.
  3. Do nothing, bringing on the crisis.

If Congress is successful, the "fear index" will likely fall even more, VXX should come down, and the options portfolio described above should make a small gain as long as VXX does not fall below $30 (present price $35.34), about a 15% drop. While VXX inexorably drifts lower because of the contango factor headwind, 15% drops over five weeks are quite unusual when VIX is trading below its mean average.

If Congress kicks the can down the road, the fear index might move higher. This should result in a nice gain for the portfolio.

If Congress fails to get its act together and do something productive, all hell may break loose. If the fear index doubles like it did in the summer of 2010 over European crisis rumors, the risk profile graph for the portfolio shows that a 160% gain would be made at the December expiration.

These seem like pretty good trading ideas to me, far better than the simple buying of puts on the market or calls on VXX.

Source: How To Use Options To Buy Fiscal Cliff Insurance Protection

Additional disclosure: I have options spreads (both long and short, puts and calls) on SPY and VXX.