Play Treasuries From the Short Side.

I am convinced that the risk markets put in a six-month bottom on November 16. The only question from here is whether we chop sideways for the rest of the year, or keep drifting up. If I see a good entry point, I will shoot out an urgent trade alert on this as fast as the speed of light permits.

The way this ends is that the fiscal cliff is resolved shortly after the December options expiration. That will produce an explosive move up in risk markets, and a dramatic selloff in the Treasury bond market. One thing I know for sure is that attempting to trade the dueling headlines emanating from Washington is a hopeless enterprise that can only end in tears.

The best way to play a market like this is with a position that has an embedded short volatility element to it, such as the iShares Barclays 20+ Year Treasury Bond Fund (TLT) December, 2012 $127-$132 bear put spread. That way, if nothing happens, you still get paid.

The Treasury bond market has been absolutely dead in the water since July. Watching the trading action has been like watching paint dry. Not even the surprise announcement of QE3 could get it off the bench.

That is because the Federal Reserve’s latest monetary easing is entirely focused on mortgage-backed securities, such as those bonds issued by Fannie Mae and Freddie Mac, bypassing the Treasury market. For this trade to work, we only need this somnolent state of affairs to continue for another three weeks.

You shouldn’t have to do anything on expiration day. The following Monday, the net profit will be credited to you account as cash, and the margin freed up. Most online brokers automatically offset your long put position with the expiring short put. It’s that simple. Such is the magic of in-the-money option spreads. But check your online account just to make sure this was done, and call them and raise hell if it hasn’t.

The best execution can be had by placing your bid for the entire spread in the middle market and waiting for the market to come to you. This alert is for the monthly options. Don’t buy the weeklies by accident. The difference between the bid and the offer on these spread trades can be enormous. Don’t buy the legs individually or you will end up losing much of your profit up front. If you don’t get filled, then just wait for the next Trade Alert. There will be many fish in the sea.

The same applies if you don’t understand this trade. Better to watch this strategy unfold on paper in the model portfolio before you try it with real money. 

Wake Me Up in Three Weeks

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