Finally, time to short the long bond (for a trade).

Here’s a two-year view of my proxy for the US 30-year Treasury bond, TLT:

Source: Yahoo! Finance. Click to enlarge.

It seems as though the mother of all Treasury rallies has run out of steam for now. I’m stepping in to play a possible correction, with a target exit range of 100-105 on TLT, corresponding to about 3.5 – 4.0% yields.

I also expect the dollar to regain lost ground at the same time, and for the Euro and Swiss franc to retrace the gains of the last three weeks.

Gold should also fall in such a scenario, as it’s price in Euros and Francs has barely changed since departing the 750 dollar level.

Whether or not to short the long bond has been the most consistent question posed by friends. I have advised against it until now, having called for sub-3% yields as early as last August. I still think this topping process needs at least another year to play out, but when nearly everyone is on one side of a trade, it is time to take the other. Simple as that.

Shorts have been burned all the way from 5.5%, and most have now given up in frustration. The news that the Fed will start buying is the perfect cherry of bullish fundamental news to complement a market top. What more could you ask? With every schmuck of a money-losing manager finally talking up bonds on Bloomberg, who else is yet to come on board?

I’m an options guy, but another way to play, besides futures, is to simply buy TBT, an ultrashort ETF.

Why do I think that yields will stay this low for over a year? Because this is the top of a 28-year bull market, and we’ve only been under 3% for a few weeks. At the last Treasury top, the 1940s, yields held under 3% for nearly a decade, even as inflation hit 10%. Market prices don’t have to make sense, in any sense other than as a reflection of mass psychology.

Disclaimer: Don’t trade like me. Don’t trade at all. It’s too dangerous out there, and this is very risky stuff, especially shorting in anticipation of a countertrend move.

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15 thoughts on “Finally, time to short the long bond (for a trade).

  1. My plan is to add a little bit of TBT each and every month going forward…..I don’t see how it doesn’t ultimately work out in a BIG way.

  2. Well, buying and holding or accumulating can be problematic with short ETFs. The way the math of daily compounding works out, volatility eats away at your position if the market doesn’t move your way in a relatively straight line. It’s best to trade each move as if it is the last. Just look at SRS — the real estate index that it tracks (IYR is the long ETF) is down 50% in 12 months, but this 2X short ETF is flat, and it has performed exactly as advertised, delivering -2x each DAY’s percentage move.

    For accumulating in anticipation of a real crash, 2011 TLT puts may be best, though these are still somewhat expensive (meaning that not ALL bears have given up).

    For a good trader, futures are a very clean way to play, using stops and taking profits when shown.

  3. Hi Mike,

    I’ve been watching some of the ETF perfomances and have been shocked.

    SRS is at about 57 and its 52 week high has been at 295.

    You note that the index it tracks is down 50%; yet, SRS performance is flat (at best).

    Can you see SRS being able to recapture some of its loses off its 52 week high. Or, can the volatility simply kill it even though the index it tracks continues to drop in the New Year? In other words, can SRS theoretically recover?

    I also noticed that DXD (DOW ultrashort) lost points today even though the DOW dropped 100 points. That seems extreme. Is that volatility at work too?

    Thanks

  4. Hi Bjorn.

    Yesterday’s Proshares action was from capital gains distributions:

    http://biz.yahoo.com/bw/081222/20081222005859.html?.v=1

    Best not to think about these things as stocks, but more like trading tools. Their performance depends entirely on how the market moves, not where it moves.

    If the market goes down a steady percentage each day, short etfs will go up by the corresponding percentage, and the daily compounding works like magic, as in SRS’s run to 300 in the crash. If the movement gets choppy, as of late, these things are crushed.

    This, along with counterparty risk, is why I got out of my short ETFs early in the crash, around Oct 1, and have just used LEAPs puts since.

  5. Mike,

    May I seek to clarify this ETF volatility for myself a bit more?

    So, for example, if Apple stock drops, as it has, I could hold it indefinitely in the hopes it could again rise. If it did rise, it would not matter how choppy that rise was. However, with an inverse ETF like SRS, if the underlying Index declines, but does so in a very choppy manner, I could still take a loss, even if the Index happened to reach the hoped for level. In other words, with the inverse ETF, simply holding and waiting could get me killed, even if the underlying Index eventually did reach my target level. It is not merely a matter making less profit due to volatility, but one could actually take a huge loss.

    I’m probably restating the obvious, but am I getting this right?

    I’m not in these right now, but I was still thinking about them for down the road when things finally turn around. I had not taken the volatility to heart. It was the counter-party risk that had spooked me.

    Thanks so much

  6. You’ve got it. I went over the math in this old post:

    http://sovereignspeculator.com/2008/08/08/inverse-etfs-vs-leaps-puts/

    You can run any scenario through in your head if you remember that the inverse ETFs deliver an inverse of each DAY’s return in the index.

    To use them successfully, you need to time the market just right on a relatively short-term basis — you need to own them only when the market is moving your way on a steady streak. Since this is very tough, I greatly prefer options.

  7. From the August post:

    “Brutal math

    The main problem with short ETFs is that as the underlying indexes get lower, small dollar moves become large percentages, especially in 2X funds. This math works against you as the market exhibits volatility on its way down. A dollar of loss in an index wins you a smaller gain in your short fund than a dollar of gain in the index from that lower level gives you a loss in your fund. Here’s an illustration:

    Imagine if XLF (a financial index ETF) goes from 20 to 19 one day, and SKF (SKF’s 2X inverse) goes from 100 to 110.

    $1 out of $20 is 5%, so SKF goes up 10%

    $1 down = $10 up

    The next day XLF goes from 19 to 20, so SKF goes to $98.42 . $1 out of $19 is 5.26%, so SKF goes down $11.58.

    XLF is back where it started, but SKF is down 1.42%.

    As many have learned in the bounce from the July 15 lows, this math can be brutal with larger percentage swings, and these moves will only get wilder as the market goes lower.”

  8. Mike,

    Thanks for including the ETF math example again. It’s kind of unnerving to watch this volatility play out with these inverse ETF’s. Your initial warning about them was timely.

    Does volatility work against you when you are going long with an ETF in the same way it does with the inverse ETF’s?

    Also, when you are using a LEAPS put option, on say IYR, is the potential volatility of IYR a concern at all (other than delaying the move toward your strike price)? Or, are you now “out of your own way,” as you once put it?

  9. “Does volatility work against you when you are going long with an ETF in the same way it does with the inverse ETF’s?”

    No. Long ETFs are just typically just baskets of stocks like index funds, though there may be some unusual ones that aim to track things like oil futures that behave in strange manners. IYR and XLF and SPY and GLD and such just own securities or metal and move with the prices of those assets.

    With options, volatility increases the premium, so when the VIX is high, it is harder to buy puts cheaply. Ideally, you want to buy when the VIX is low (like Spring 07) and sell when it is high (like Oct-Nov 08).

  10. Hey Mike, any new thoughts on holding cash inside the US? (Aside from “don’t do it” heheh)? Now that T-Bill yields are down to zilch, safes and safe deposit boxes seem like the least bad options.

  11. I really enjoy following this site. Back to the main subject: shorting long bonds. “Never bet against the Fed” is supposed to be one of the basic tenents of trading. Let’s assume you are right, however. It seems the Fed has the ability to keep rates down for months and months. So why the rush? Is it because 2011 TLT LEAPs give one plenty of horizon to work with, i.e., better buy now than miss out?

  12. This is just a short-term trade I’m making because I think the bond is overbought. I think it will come back after any correction.

    It is nowhere near ready to crash yet, because there are still too many guy like us ready to short it. We all need to give up first.

    Look at the charts in this old post that show how long yields stayed ridiculously low while inflation raged in the 1940s:

    http://sovereignspeculator.com/2008/08/08/that-crazy-crazy-bond-market-a-call-for-sub-3-long-bonds/

  13. No, TLT pretty much does what the long bond does, so there is no problem with a straight short. I just never short that way, since it requires a margin account, lots of cash, and very good timing. I’ve always preferred options, but to each his own.

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