If Congress surprises no one by doing nothing, on Jan. 1 the U.S. will fall off the Fiscal Cliff. As taxes rise and government spending drops, jobs will disappear as the U.S. economy enters recession again. The market goes down faster than it goes up, so do something hedge funds do: make money while everybody else is losing it.
If you have some money to risk and believe there's some chance Democrats and Republicans won't work out their fiscal differences in time, buy call options on Guggenheim Inverse 2x S&P 500 (NYSEARCA:RSW). With a Beta of -1.85, when the market does poorly it does the opposite and then some. It's trading at $22.33 now, but when the market bottomed out in March 2009 it sold for eight times more at $180.59. If we fall off the cliff, RSW will do great because the stock market will decline.
Call options let you lock-in an asset's future purchase price, so let's do some math. Here we pay $1.00 for the right, but not obligation, to buy RSW for $25 anytime between now and Jan. 18. If the price rises to its recession high, you could earn $180.59 - $25 - $1.00 = $154.59 per option. That's a 15,459% return!
The table at left shows how much money you will make at different price points. Of course, if the price ends up below $25, you lose all your money. But clearly, there's a huge profit potential here, so what do you think the chance is that Congress actually does nothing? Even if they avoid the cliff, some other exogenous shocks like foreign recessions, major natural disasters, or wars hurting trade could pummel the markets and benefit RSW. I can't predict the future and neither can you, let alone accurately assign probabilities to price levels. However, even if we err conservatively with a 10% chance of going off the cliff, this investment still yields a positive expected return.
We don't know what value RSW will reach, but it's possible, albeit unlikely, it will exceed its all-time high. I'm arbitrarily picking $190 as the upper possibility then dividing the range by two to average it.
I'm not predicting we will go over the cliff. In fact, I doubt we will. However, even with a 90% chance Congress acts (Is that too much confidence?), it can be financially justified to buy this call option.
Two days after our option expires, on Jan. 20 a new Congress and possibly a new president will be sworn in. This increases the chance of a governmental response to falling off the cliff, which could bunt gains for RSW. The first part of 2013 could be mired in recession and uncertainty, so our Jan. 18 expiration date works well.
Now if America fails, you can make a lot of money, so do another thing hedge funds do: pay someone to lobby Congress to act and vote according to your portfolio's best interests.