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Was Bond Pullback A Top, Or A Reload?

February 2, 2012

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Was bond pullback a top, or a reload?

There is no doubt that Treasuries are overvalued from a long-term perspective, but in the short run there is no measure of just how irrational investor behavior can become. Remember the negative yields for bills in 2008? Accordingly, bears shouldn't complacently believe that rates "can only go up from here" (which means bond and notes would fall).

While that assumption is true for those that have unlimited capital and all of the time in the world, those trading in the "now" might have a different experience. We aren't necessarily bullish but we certainly respect the market's yearning for stop running and torture. Also, we understand that investors are acting on the fumes of emotion rather than logic; therefore, the old "rulebook" has been all but destroyed.

Being bearish in what has been a decade (or more) bull market, requires that traders patiently sell into strong strength to survive. Selling quiet markets or chasing them lower simply doesn't work in this environment.

As discussed in previous newsletters, Friday's government employment report could be the deciding factor on the Treasury market's near-term direction. Most analysts are expecting that the economy added somewhere between 100,000 and 150,000 jobs last month. In light of ADPs 175,000 prediction earlier this week, our guess is that any number between 100,000 and 175,000 would be a non-event. A sub-100,000, on the other hand, could prove to trigger a round of short covering that leads the 30 year bond near 146, and possibly as high as 146'20. A similar move in the note could see 132'16ish. If these levels are seen on an early morning rally, we like the idea of being bearish at such prices...it seems as though longs could be interested in locking in profits and a move to these prices will ensure that a majority of the buy stops have been run.

From a previous newsletter, but still something to be aware of:

You've likely heard of the VIX, a volatility index based on the S&P 500 but you probably aren't familiar with the MOVE Index. This is an index created by Merrill Lynch that measures overall volatility in the Treasury market. Specifically, it is a "yield curve weighted index of the normalized implied volatilities" that accounts for the 2-year notes, 5-year notes, 10-year notes and 30-year bonds. The MOVE index is currently trading at a value of 75 after peaking near 116 in November. Yet, Treasury option prices in the futures market seem to be rather beefy.

For instance, many clients are currently holding a short 140/149 strangle worth about 46 ticks or $720. Prior to the August fiasco, traders would have likely had to sell options with strike prices within 2 or 3 handles of the current markets price to collect similar premium. Either the options are futures are dramatically overpriced, or they are trying to warn us of something. For now, we are choosing the overpriced side of the argument. After all, we are headed into a plethora of economic data (namely the employment report) and traders are likely buying lottery tickets on both sides of the market.

* Due to time constraints and our fiduciary duty to put clients first, the charts provided in this newsletter may not reflect the current session data. However, market analysis and commentary does.

**Seasonality is already factored into current prices, any references to such does not indicate future market action.

Treasury Bond and Note Option and Futures Trading Recommendations

**There is unlimited risk in naked option selling.

1-17- Clients were advised to sell the March 5 year note futures contract near 123'19 and purchase the June 123.5 call for about 43 ticks to insure the trade (limit risk to about $650ish before commissions and fees). This trade has a lot of time, unlimited profit potential and closed risk.

1-23 Clients were advised to lock in a profit on the short 5-year note futures contract near 123. Depending on fill prices, this leg of the trade netted about $550 to $600 per contract before transaction costs. We are still holding the long call that was purchased for protection.

1-23 - Clients were recommended to sell the March Bond 134 puts for about 29 ticks, or $453.

1-25 - Clients were advised to buy back their short 134 puts for about 13 ticks prior to the Fed announcement. Assuming an entry of 29 and exit of 13, the profit was $250 per contract before commissions.

1-25 - It was recommended that our clients re-sell the 5-year note futures contract (bought back at a profit on Monday, see above) near 123'23. In light of the profit on the first entry, this is now nearly a free trade (ignoring transaction costs and slippage), limited (almost no) risk and unlimited profit potential from here.

1-25 - Clients were advised to sell March strangles using the 137 puts and the 147 calls for about 47 ticks or $735.

1-30- Clients were advised to buy back their 137/147 bond strangles, for a small loss and replace the premium by selling the 140/149 strangles...to give the market a little bit of breathing room.

In other markets....

1-18 - Clients were advised to sell March S&P 1370 calls near $9 in premium ($450 per mini contract).

1-23 - Clients were advised to sell March Euro strangles. It was recommended that those holding long 137 calls (as a flyer just in case of a short covering rally) sell the 136.5/123 strangles for about 69 ticks or $862.50. Traders without this long call, sold either the 138/122 strangle or the 127.50/122 strangle for about 44 ticks or $550.

1-26 - We recommended that clients offset their long March Euro 137 calls near 40 ticks to lock in a profit of about $250 per contract. This leaves our short strangle unhedged.

(Our clients receive short option trading ideas in other markets such as gold, crude oil, corn, soybeans, Euro, Yen, and more. Email us for more information)

Carley Garner

Senior Analyst / Commodity Broker

DeCarley Trading

cgarner@DeCarleyTrading.com

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*Due to the volatile nature of the futures markets some information and charts in this report may not be timely.

There is substantial risk of loss in trading futures and options.

Past performance is not indicative of future results. The information and data in this report were obtained from sources considered reliable. Their accuracy or completeness is not guaranteed and the giving of the same is not to be deemed as an offer or solicitation on our part with respect to the sale or purchase of any securities or commodities. Any decision to purchase or sell as a result of the opinions expressed in this report will be the full responsibility of the person authorizing such transaction.