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Back in February we did a very successful option trade with TLT. We described it in an article posted in the first week of March (A Contrary Option Trade with TLT). At the time, we projected that it might eventually be the best trade of 2011. Very few paid any attention to this trade, and some thought that we were intellectually challenged for suggesting it. After all, the famous Bill Gross drastically reduced his exposure to long dated Treasuries in March and noted analysts were consistently detailing how shrewd this move would prove to be over time.

Since then, Mr. Gross has apologized for his “mistake”. Recently, he has apparently reversed his position. While we do not necessarily view Mr. Gross as a walking, talking contrary indicator, there are a number of other factors that make a similar option trade using the inverse ETF, ProShares UltraShort 20+ Year Treasury (NYSEARCA:TBT), compelling at this time.

From the Proshares website TBT is described as follows:

This Short ProShares ETF seeks a return that is -2x the return of an index or other benchmark (target) for a single day, as measured from one NAV calculation to the next. Due to the compounding of daily returns, ProShares' returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period.

While this fund is not a perfect trading vehicle for extended periods, we are not trading the fund itself, but its options. As we describe below, we are trading the options at a credit with limited exposure of our capital.

Simply put, we think that the surge of funds into Treasuries, especially since late July has been largely overblown. The aversion for risk among many investors wishing to avoid a repeat of 2008 has been an important component of the cause. Now that the Fed has “responded” to the ongoing European fiscal crisis with another dose of what in effect is another round of monetization, the fear among the risk averse will likely subside.

Stated otherwise, what happens to the stock market when the selling has dried up? We think that the markets are due for a significant rally; the result should cause larger inflows of capital into the stock market within the next month or so when greed overtakes fear and the risk of missing another “March 2009” will be too great a temptation for most investors and fund managers to ignore.

Technically, the TBT candle chart is displaying a double bottom pattern with support at 18.00 and we have identified Fibonacci resistance points at 23.20, at 27.25 and 30.00. The point and figure chart is forming a nice base, and will break out convincingly at 20.75.

We view volatility as another important factor in weighing the effectiveness of a TBT option trade at this time. Generally, we buy stock (and sell puts) when the CBOE SPX Volatility Index (VIX) and CBOE OEX Volatility Index (VXO) range above 35.00. We will be selling stock when these indicators are below 20.00. Accordingly, we have been buying stock and aggressively selling put options for the past two or three months. However, the time for accumulation may be about to come to an end.

In order to take advantage of the temporary break in the upward trend for long dated Treasuries, we have initiated the following positions:

  1. Sell 2013 January 20 TBT puts for 3.90;
  2. For each put we sell, buy 2 March 20 TBT calls for 1.45 each.

This trade is done at a 1.00 credit (we like to get paid to trade). This makes sense, as option implied volatility for this security is reasonably high. Depending upon the timing and strength of the move, we will likely take profits at the Fibonacci milestones identified above before mid-March. At that time, we will evaluate whether to buy calls in more distant calendar months, or simply hold (or buy back) the short puts.

The features we like best about this trade include:

  • We essentially double our leverage over merely buying shares in TBT;
  • We gain exposure to TBT's March call options at a credit;
  • We reasonably define our risk based upon chart support; and
  • We put ourselves in position to make significant profit as long dated Treasuries decline in value over the next several months.

Will this be the best trade in 2012? Actually, we think that by spring, long dated Treasuries (NYSEARCA:TLT) will present us with another golden opportunity to benefit from yet another stampede into the largest, most liquid safe haven in the world.

Disclosure: I am short puts and long calls in TBT

Source: A Contrary Option Trade With TBT