Trouble in Bond Paradise?

Jun 16, 2014 | bonds, trading strategies

With the Fed “pumpin’” and the economy “thumpin’” (as in “thumping along like a flat tire”) it seems unlikely that interest rates would rise.  Still, sometimes is makes sense to go against the grain if enough evidence presents itself.  So let me show you what I am looking at in the bond market.

EWJ vs. T-Bonds     
As I wrote about in a previous article (T-Bonds and Japanese Stocks, Inversely….), for whatever reason, t-bonds have long exhibited a strong inverse correlation to Japanese stocks (no, seriously).  In Figure 1 we see EWJ (the ETF that tracks Japanese stocks) with a 5 week and 30 week moving average drawn in the top clip.  In the bottom clip we see ticker TLT (the ETF that tracks the 30-year t-bond). You can see that – using highly technical terms that we quantitative analysts types like to use to impress others with how much we know about the markets – when EWJ “zigs”, TLT tends to “zag”, and vice versa.

This past weekend the 5-week moving average for EWJ once again rose back above the 30-week moving average for EWJ.  If history is an accurate guide then this may be a negative sign for t-bonds.  Although I would be remiss if I did not invoke:

Jay’s Trading Maxim #216: History is not always an accurate guide (but it beats flipping a coin).
Figure 2 displays the raw dollar gain or loss from:

a) Holding a long position in t-bond futures (1 point movement = $1,000) when EWJ 5-week is below EWJ 30-week (red line)
b) Holding a long position in t-bond futures (1 point movement = $1,000) when EWJ 5-week is above EWJ 30-week (blue line)

Obviously this indicator is not perfect, but equally obvious is the fact that bonds have typically performed better when the EWJ 5-week MA is below that EWJ 30-week MA. So let’s call this – if nothing else – a potentially negative sign.

TLT vs. Elliott Wave
I am not a true “ElliottHead” but I do tend to pay attention to the Elliott Wave count for a given market when the daily and weekly counts point in the same direction.  Figures 3 and 4 present the latest daily and weekly Elliott Wave counts for TLT as figured by ProfitSource by HUBB.
The daily count just completed a bullish Wave 5 (i.e., implying that the latest rally has run its course) and the weekly count is signaling a potentially Bearish Wave 4 sell signal.  For the record, I do not believe in the “magic” of Elliott Wave.  But I do like when daily and weekly signs for just about any indicator appear to confirm one another.

Ways to Play
So if a trader buys the idea that t-bonds will decline in price in the months ahead, there are lots of way to play.  A trader could:
*Sell short 100 shares of ticker TLT.  This would require roughly $5850 of margin money and would technically entail unlimited risk. 
*Trader could buy 100 shares of ticker TBT, an inverse leveraged ETF that is designed to track t-bonds times minus 2 (In other words, if bonds decline -1%, then ticker TBT should rally roughly +2%).  This would require roughly $6,200.
*Buy a put option on ticker TLT.
*Buy a call option on ticker TBT.
There are pros and cons to each, but the trade that I want to highlight is buying a call on ticker TBT.

Call on TBT
If t-bonds do decline, then TBT would be expected to advance, hence the reason for considering a call option on TBT.  The reason I am looking at this trade is simply because it offers the most “bang for the buck.”  Not only are TBT shares leveraged 2 to 1, but by buying a call option we can obtain even more leverage with limited risk.  As you can see in Figure 5, TBT has support at roughly $56 and resistance at roughly $80.

 

So let’s look at buying the September 62 call for $281 (NOTE: the bid/ask is fairly wide at $2.62/$2.81.  For illustrative purpose I am simply assuming a market order and a fill at $2.81.  An astute trade might consider a limit order that splits the difference).  Figure 6 displays the risk curves for buying the Sep TBT 62 call at $2.81.

As you can see, in the worst case the maximum loss is $281.  In the best case – i.e., TBT rallies all the way back up to $80, the trade can generate a profit in excess of $1,500.  Also there are three months for “something” to happen. 

Summary
As always, I am not “recommending” this trade.  I am simply pointing out some potentially bearish evidence that I have found in regards to t-bonds and have highlighted “one way” to play such a situation using the limited risk associated with options.

So will t-bonds take a tumble and in turn, will TBT soar, thus generating an excellent rate of return?  As always, “It beats the heck out of me.” But from a trader’s perspective, the real question is, “Am I willing to risk $281 to find out?”

Jay Kaeppel  
Chief Market Analyst at JayOnTheMarkets.com and AIQ TradingExpert Pro (http://www.aiq.com) client

What to Watch for Now in Stocks and Bonds

Jun 5, 2014 | bonds, trading strategies

Watching Weekly Dow Momentum
The stock market – like the Energizer Bunny – just keeps chugging along, with the Dow, the S&P 500 and the Nasdaq 100 all touching new highs in the last week (the Russell 2000 small-cap index is another story, and may ultimately serve as the “canary in the coal mine”, but for now “majority rules”).  So for now, disciplined trend-followers (“Hi my name is Jay – although it is a little difficult to speak at the moment as my teeth remain tightly clenched”) have done well to avoid all of the “Sell in May” warnings from all of those so called experts (“Um, hi my name is Jay?”).   But there is one sign that I think investors should follow that has historically proven useful during the middle months of mid-term election years.  

I first wrote about this on 5/6/2014 in an article titled “A Warning Sign to Watch“.  For full details I suggest you read that article, but for now let me give you the gist.

-Between May and October of mid-term election years, a warning sign occurs when the MACD Oscillator (many traders refer to it as the MACD Histogram) drops into negative territory.

For the record, the MACD Oscillator was below 0 during early May, but was in a rising trend along with the Dow itself.  The Oscillator returned to positive territory on 5/23 and remains there still.  So let me sum up my advice as succinctly as possible:

*KEEP AN EYE ON THE WEEKLY MACD OSCILLATOR FOR THE DOW JONES INDUSTRIALS AVERAGE. 

If it drops into negative territory be prepared to take defensive action.
If you have even the most basic charting software, checking the status of the weekly Dow MACD Oscillator after the close each week will take up approximately 12 seconds of your time.  Per the 5/6/14 article, if history is any guide, the 12 seconds a week time investment may prove to be very useful.

Looking for a Reversal in T-Bonds
As I write, t-bonds are in the middle of a nasty short-term sell off.  But there is hope.  As I wrote about on 4/8/14 in an article titled “A Simple Signal for Bond Traders”, a short-term bullish setup may be forming at the moment.  In a nutshell:

*When the 25-day moving average for ticker EWJ is below the 150-day moving average for ticker EWJ (long story short, t-bonds tend to trade inversely to Japanese stocks – go figure), then
*Wait for the 10-day CCI (Commodity Channel Index) for ticker TLT to drop below -100 and then turn up for one day.

Once that occurs a trader might consider buying the call option with at least 40 days left until expiration and the highest gamma among call options for that expiration.

In Figure 2 you can see that this setup is presently “locked and loaded” and will be triggered when the 10-day CCI for ticker TLT reverses back to the upside.

Traders should always remember that there is never any guarantee that the next signal will generate a profit, and should always have some sort of stop-loss or risk limiting planin place at the time that any new trade is entered.

Jay Kaeppel  
Chief Market Analyst at JayOnTheMarkets.com and AIQ TradingExpert Pro (http://www.aiq.com) client