As the Volatility Index (VIX) surges to a new record high of 89.53, investors and traders are running for the hills, but where are they running to? There are many ways to either protect your portfolio or to seek safety, but that protection comes at a cost, especially when you are late to the party. High volatility makes options expensive and reduces your flexibility, but also produces certain strategic alternatives. As this is an important topic to investors at the present time, I will try to be as extensive as possible in the following analysis.

First I will focus on a few strategies to protect your portfolio. Following that I will look at several safe havens, their performance and outlook.

A Few Strategies

Defensive Puts

In times of trouble investors will often buy puts to protect the entire value of their portfolios. This can be done by either buying single stock puts if there is a large core holding to protect, or by buying index puts of a similar nominal value to the entire portfolio. The second option does come with its problems. There might exist significant basis risk - the risk that the hedging portfolio does not properly track the underlying portfolio. In the current market environment some might argue that this is not a very important issue as most of the value being extracted in the market is caused by a rising market risk premium and not factors specific to individual companies. That being said a fully effective hedge would require as accurate a tracking portfolio as possible to offset all risks.

Yet is this a viable strategy right now? I would argue that it's simply too expensive unless you determine that greater risk exists than the market is implying. At a level of volatility in the 80's, the market is expecting massive daily swings like we have been seeing. This expectation is priced into options through its implied volatility. This has resulted in the cost of at-the-money protective puts skyrocketing and thus making it very expensive to protect your portfolio. You could buy out of the money puts - although they do carry the high premium as well. The problem with that strategy is that you have to be even more pessimistic about the market. An option 10% below market expiring at the beginning of December is going to cost you about 5%. That means that if the market doesn't fall more than 10% in the next 5-6 weeks, you've accumulated an additional 5% loss - the cost of the premium.

Covered Call Writing

OK so let's get this volatility and high option premium to work in our favour. Once again this strategy isn't without risk. Let's say that you own 100 GOOG shares currently sitting at around $340. A call option with a strike price of $370 currently costs $21 expiring in December as well. That's close to a 6.2% premium if you sell it. In other words, it will afford you 6.2% of downside protection until December, or protection down to $319. If the shares hover around the current price, you pocket the premium. If the shares go up but not above $370, you pocket the premium.

If volatility decreases before expiration, even if the shares slowly move up, the option will likely decrease in value and you might be able to buy the option back at a profit even in a rising market. The risk in this strategy is that the shares go flying up and at expiration they are called away from you. This would result in an exist price of $370 + $21 premium = $391. If you bought the shares for more than that, you may be locking in a loss. The other risk is of course that the shares fall below $319 in which case you only have limited protection and will start accumulating losses.

Moving to Cash

The first instinct of a person facing large losses is to sell and move the money to cash. All advisors will tell you that now is not the time to sell, but this is a part of their training. By looking at historic trends, selling equities at a time like this was a bad mistake and that is what they base their advice on. I prefer to stay neutral in this discussion as it is a difficult question to answer. Looking at what happened in Japan, the Nikkei topped on December 29, 1989 at 38,957.44. Today it is sitting at 7649.08. Taking a look at the chart, there were a few years where buying equities was a good play (yellow circles), but obviously not a good strategy in the long term. The green circle likely represents where we are currently sitting, after sharp downward movements, assuming we enter a Japan like slump.

However, the Jury has not come in with its verdict as to whether or not the U.S. will meet the same fate as Japan. Bernanke and Paulson are all too familiar with what happened in Japan and will do whatever they can to avoid that deflationary spiral. That being said, they may in fact cause an inflationary spiral and the consequences of that are unknown.

The one point that I must point out is the 'cash is king' mantra. While cash may be the best place to be right now, one must be careful as to how much value they put on that cash in terms of future growth opportunities. Japanese companies were and continue to be cash rich. The problem is that there are no stable growth opportunities to invest that cash in. In fact, Buffett gave a lecture around the time of LTCM and was asked if he will invest in Japan because borrowing costs are so cheap. He said that even at 0% interest rates, finding a stable 1% ROE is difficult. In a deflationary environment cash is king because its purchasing power increases over time, not necessarily because you can buy cheap assets. If cash is perceived to be the best investment, what does that say about the investing environment?

I'm 50/50 as to whether or not we'll see similar times to Japan, however the 50/50 is full of risks on both sides. Cash is a great investment in deflationary times and the worst in inflationary times. This time around Buffett expects inflation and real credit expansion which could result in a massive bull run in equities. For this reason, moving into cash right now likely has significant risks.

Safe Havens

In order to analyze the safe havens properly, one must accept that these assets are subject to supply and demand. Simple economics 101 theories do not have the capacity to make effective investment decisions at this juncture. And with that disclaimer, let's begin with gold.

Gold

As expected, I was largely ridiculed a few weeks ago when I started to get aggressive in my expectation that gold prices must come down. "You're an idiot, look what the Fed's doing" was a common criticism from the masses. Yet since that time we saw as much as a $170 swing down to an intraday low of around $680. This move can be attributed to many factors: weak consumer demand, increasing deflation expectations, pawning of jewelery (probably not out of choice). Yet what's more important in my view is the rush into gold by investors that drove gold prices up above its fair value in the first place.

There has been much chatter amongst the conspiracy theory community as to why many dealers are reporting shortages of gold coins. "Not enough gold to produce the coins" has been echoed on various blogs and forums. Yet no one stops to think that maybe we're just seeing the classic sign of a bubble - the retail investing public piling their money into an asset, buying every gold coin in sight. It's a very visible development as the physical nature of gold makes excessive buying obvious, whereas the dot com bubble never saw any shortages as it was very easy to simply IPO a new company and create value out of nothing. This stampede into gold has supported gold prices, when all comparable stores of value have been crashing. This led me to believe that a sharp downward move was imminent.

Have we washed out the excess value? I don't know. I am not shorting the yellow metal anymore as risk is now more evenly distributed on both sides, although I still believe the bias is slightly negative. To the conspiracy theorists, what do you make of the fact that every second commercial on CNBC and Bloomberg is the U.S. mint advertising to buy their gold coins? If they are manipulating gold as many of these people theorize, is this not a very bearish sign?

When credit reaches the market, if it ever does, gold prices will soar - but from its real value. If at the time the nominal value is significantly above its real value, the rally won't be as violent. Gold bulls were making a trade that still had several trades ahead of it in my opinion. First - the flushing of excess value which has largely occured. Second - increasing yields on treasuries, especially on the long end of the yield curve, as lending money to the government gets more risky. Finally, the government is forced to print fortunes of money because the interest rates that the market demands are simply too expensive.

The gold safe haven play has been going on for years now as credit wildly expanded - the question now is whether or not gold itself is currently inflated. In the long term gold is a true store of value, but in the short term it is subject to the same laws of supply and demand as any other asset. Buying at any random point in time is a commodity trade and storing value is not a guaranteed attribute of the precious metal.

Japanese Yen

Taking a look at the Japanese Yen, we see the opposite trend of gold, which is why the Yen has significantly outperformed gold this year. Prior to the credit crisis, there was a flood of money into gold as credit had rapidly expanded. On the contrary with the Yen. As credit expanded, more and more investors borrowed money in Yen at 0.0% - 1% and invested abroad. Even local Japanese investors were sending all of their money abroad in search of a good return - as it didn't exist in Japan as mentioned above. This resulted in massive selling of the Yen which continued to weaken for an extended period of time.

The Yen has been a great safe haven, not because of its intrinsic properties, but because the reversal of this trend was imminent. For those who use the debt-to-gdp as a sign of a weak government balance sheet and a risky currency, Japan is number 2 on the list, after Zimbabwe. The repatriation of the Yen has nothing to do with the Yen's fundamentals but rather the unwinding of the carry trade and the normalizing of currency imbalances. Also, they are not really in the position to cut interest rates as the BoJ's stated aim is to normalize interest rates. This has led to a decreasing interest rate differential between the Yen and the other currencies - decreasing the incentive to hold short Yen positions.

No one knows how much of the Yen carry trade has been repatriated - but this move is mainly a direct result of currency flows. If the financial system continues to de-lever and we see additional hedge fund failures and redemption's in the future, we will likely continue to see money returned to Japan, putting continued upward pressure on the currency.

Swiss Franc

The currency that is supposed to be the safe haven is the Swiss Franc. However, many people have been disappointed with its performance through the crisis. Here is a list of fundamental issues currently affecting the Franc:

1) International Relations.

• Libya is said to be pulling all of its assets out of Swiss banks following a diplomatic issue.
• There is a continuing probe by the DoJ into tax evasion by wealthy Americans through the use of Swiss banks. This is putting downward pressure on demand for CHF as the risk for wealthy Americans increases.
• Germany is joining the party by saying that Switzerland should be placed on the OECD's list of international tax havens.

2) The Swiss Central Bank has co-ordinated a massive bailout of its major banks. This is uncharacteristic of the Swiss who are known for valuing strict monetary policy and the safety of their currency.

3) Risks of exposure to European banks and the EU's deteriorating fundamentals.

4) Low bank guarantees compared to other developed countries ($26,473).

These forces have outweighed previous historic trends of the CHF benefiting in times of risk aversion. Moving forward, a lot of what will happen depends on how authorities deal with the recent attacks on their banking structure and whether or not the central bank returns to a more prudent strategy. However, the relative under performance of the Swiss Franc makes sense given these developments.

U.S. Dollars & Treasuries

For a similar reason to the Yen strength, the dollar has been strengthening as well. I'm not going to get too much into this as I recently wrote an article covering the rise in the dollar. Essentially repatriation is the name of the game and massive amounts of money are chasing treasuries for any yield they can find. This past week, U.S. 30 year treasuries fell to their lowest yield since regular sales began. It dropped to a 3.8676 percent, an amazingly low figure for a 30-year period. This at a time when the fiscal balance sheet is as poor as it's ever been. While in the short term this yield may be subject to the further lowering of interest rates, the longer term holds a different picture. I can not imagine that a few years from now people will be willing to lend the U.S. government money for this yield. That being said, with ridiculous amounts of debt, Japan's yield on its 30 year is 2.25% (see yield curve chart).

Summary

The rush into safe havens has distorted values. What makes all of this so complicated is that these values are distorted values of previously accepted distorted values. In the short term, safety will likely be found in the U.S. dollar, the front end of the yield curve and the Yen. Pending developments, the Swiss Franc may also qualify. That being said, switching out of battered equities into expensive treasuries would be exactly the opposite of what long term value investors like Warren Buffett are doing. Choose that course of action at your own risk.

Disclosure: Owns Yen, USD, some CHF.