How To Play the Long Bond (TBT, GLD, SLV, PTM)

Register for the LA Trader's Expo for Free Here!

With the recent troubles on the European front, market participants have been flocking to U.S. Treasuries once again. This has pushed bond prices higher and yields lower as of late.

Recent market statistics are supporting the idea that, while inflation is tame in the near-term, there could be an influx of inflation later on down the road. I, for one, see inflation starting to rear its head in the second half of 2011.

Some prices have already begun to reflect increased expectations for higher inflation, such as gold (NYSE: GLD), silver (NYSE: SLV), and platinum (NYSE: PTM). They have run higher, retracted, and are now looking for reasons to move higher once again. While I believe that holding a basket of these three metals, as well as copper, is a terrific inflation and volatility hedge for long portfolios, I think there is a better way to make a pure-play inflation bet.

I want to short the Long Bond. While it used to be hard for individual, retail investors to get short bonds, with the recent influx in ETFs this has become much easier. Take a look at the PROSHARES ULTRASHORT 20+ YEAR TREASURY (NYSE: TBT); this ETF allows you to double-short the long bond. By doing this you are not exposed to margin calls or coupon payments, as you would be if you were to short actual bonds. This takes much of the extra downside factors off the table so you can focus on you principle thesis of being short bonds.

For me the best way to play this ETF is through the options market. By doing so you can structure a trade that voices your short bond thesis, does it for less money upfront, gives you a chance to make money even if inflation does not pick up, and receive a yield on your cash in the mean time. Wonder how you can do that?

That’s where I come in. I recently put in this trade:

Buy the January 2012 $40/50 call spread for $3.00 and sell the January 2012 $35 put for $6.00. Net credit on the transaction is $3.00.

Lets see what this does for us…

1.You voice a short bond position. If inflation arises over the next 18 months, you have a chance to make money as this ETF rises. Max gain is $1300, a gain of nearly 40% on total potential invested capital and a gain on invested margin of 173%.

2.You voice you opinion for less upfront cash. If you just purchased the ETF today, you would shell out $3800. By executing the above options trade you will be putting up only $750 for margin. This leaves you more free cash to trade other instruments.

3.You get paid to execute the trade. With the options trade you receive $300 up front, a yield on your invested margin of 40% or a yield on potential invested capital (if you were obligated to buy the shares) of 9.375%. That’s a yearly yield of 6.245%. Think you can find a CD that pays that much? I don’t think so.

4.If bond prices move higher, you will be entering into a short bond position at a better cost-basis than if you purchased today: $32, a discount to today’s price of nearly 16%.

In short, this is a much better way to play increased inflation expectations.