Why My Favorite Trade of the Decade Could Be Starting Now

It’s a sobering picture.

The global financial system is in dire straits. Resuscitation now looks doubtful.

 

Debt burdens are at epic proportions on every level – global, national, state and local.

And now the Keynesian argument to spend more through exponential expansion of credit is about to be exposed as a fraud.


But I could care less which side is right; Keynesians or Austrians. Frankly, it doesn’t matter to me. I am only concerned how self-directed investors and traders can take advantage of the situation.

 

And this situation is setting up what I consider to be the trade of the decade. Simply put, this trade is to short U.S. Treasury bonds. This is almost a no-brainer in my opinion.

 

In my view, one can’t ignore the current failures that are the direct result of the ‘prosperity boom’ that began in the 1980’s. This ‘prosperity boom’ came on the backs of ever-expanding credit and debt.

 

And now advanced economies are witnessing the damage of the flawed theory firsthand.

 

Ireland, Spain, Portugal, Greece and Italy all are in trouble. The top five largest economies, including the U.S. are not far behind.

 

Those in the know realize the collapse is imminent and they are not hiding their opinions. Bernanke and friends essentially told the global market that U.S. growth would be stagnant for several years as the fed planned to keep interest rates low through ‘at least’ mid-2013.

 

Maybe the fed said ‘at least’ because they really can’t afford to admit that they agree with the International Monetary Fund’s recent assessment that global debt issues would persevere for ten years, or more. Director Christine Lagarde warned of the risk of a ‘lost decade’ for the global economy unless nations act together to counter threats to growth.

 

“In our increasinglyinterconnected world, no country or region can go it alone,” Lagarde said in a speech to a forum in Beijing several weeks ago. “There are dark clouds gathering in the global economy.”

 

But haven’t we already experienced a lost decade? Just look at the S&P’s performance over the past
ten years.

And now that the U.S. and other leading economies have exhausted every effort to inject life into the global economy, we are left with bleak GDP growth and inevitable inflation woes.

Yet, with bonds of leading economies becoming ever riskier, the world is still looking to the U.S. for a stable return – or what many on Wall Street call ‘the safety trade.’

 

This could last for several months, if not several years. And with more money piling into U.S. Treasuries, interest rates could push even lower.

Just look at what effect ‘the safety trade’ has had on U.S. bond prices. Remember that as yields fall, bond prices rise.

The 10 year chart of the iShares 20+ Year Treasury Bond Fund (NYSE: TLT) above is evidence of how interest rates and the bull market in bonds has evolved since 2003. If you look towards the right side of the chart you will notice what should be the final stages of the decade long bull market in bonds.
There is no doubt that the move in 2011 has been parabolic with Treasury bonds soaring over 40%.

Fortunately for the bond bulls, given all of the world’s troubles, ‘the safety trade’ still looks intact. But, how much longer can rates stay at record lows? Realistically, the reward is now to the downside.

 

And that is exactly why I think shorting TLT or buying TBT could be the trade of the decade.

 

I mention TBT because it is a more aggressive ultrashort for 20+ Year Treasuries. Because of my conviction that the bond bubble will eventually burst wide open, I want to have some exposure to an aggressive ETF.

 

So how would I play TLT or TBT?

 

You could simply short TLT or buy TBT- both are easy to do.  However, I prefer to use a more logical, strategic and intelligent approach – options.  

There are various ways that you could use options to take advantage of the previously made
assumptions.

The following is probably the most simplistic approach.

If you prefer to have duration on your side you could simply buy LEAPS puts on TLT or LEAPS calls on TBT with the intent to roll them out further if bonds remain stagnant or rally.

LEAPS, or Long-term, Equity Anticipation Securities, are long-term options that typically have a
life of 2 years or longer.

 

The reason I would use LEAPS is because I prefer not to tie up a significant amount of capital to one position. Yet, I still want a decent amount of exposure to the bond market and, so a leveraged position like LEAPS allows me significant, defined exposure.

The Trade Arena

Now, you need to pick a strike price.

Some of  you may wish to purchase a LEAPS call that is deep in-the-money. (“In-the-money” means the strike price is below the current stock price.) A general rule of thumb to use while running this “in-the-money” LEAPS strategy is to  look for a delta of .80 or more at the strike price you choose.

Remember, a delta of .70 means that if the stock rises $1, then in theory, the price of your option will rise $0.70. If delta is .85, then if the stock rises $1, in theory your options will rise $0.85, and so forth. The delta at each strike price will be displayed in the option chains of the underlying of your choice.

The deeper in-the-money you wish to go, the more expensive the option price. Why? Because it will have more intrinsic value. But the benefit is that it will also have a higher delta. And the higher your delta, the more your option will behave as a stock substitute.

However, you must always keep in mind that even long-term options have an expiration date. If the stock shoots skyward the day after your option expires, it does you no good. Furthermore, as expiration approaches, options lose their value at an accelerating rate. So pick your time frame carefully.

As a general rule of thumb, consider buying a call that won’t expire for at least a year or more. That makes this strategy a fine one for the longer-term investor. After all, this type of strategy is seen as an investment, not pure speculation.

Now that you’ve chosen your strike price and month of expiration, you need to decide how many LEAPS calls to buy. You should usually trade the same quantity of options as the number of shares you’re accustomed to trading.

If you’d typically buy 100 shares, buy one call. If you’d typically buy 200 shares, buy two calls, and so on. Don’t go crazy, be smart, because if your call options finish out-of-the-money, you may lose your entire investment.

Now that you’ve purchased your LEAPS call(s) or put(s), it’s time to play the waiting game. Just like when you’re trading stocks, you need to have a predefined price at which you’ll be satisfied with your option gains, and get out of your position. You also need a pre-defined stop-loss if the price of your option(s) decline sharply.

Remember, trading psychology is a large factor in becoming a successful, long-term options trader. Be consistent. Stick to your guns. Don’t panic. And don’t get too greedy.

This is a marathon and not a sprint.

Until next time,


Andy Crowder

Editor and Chief Options Strategist

Options Advantage

— Andy Crowder - Options Advantage

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