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Playing the Short Side with Vertical Bear Put Debit Spreads

note: This is a repeat article for our many new subscribers.

For me, the glass is always half full, not half empty, and it’s usually darkest just before the dawn. After all, over the past 100 years, markets rise 80% of the time, and that includes the Great Depression.

However, every now and then, conditions arise where it is prudent to sell short, or make a bet that a certain security will fall in price.

This could happen for myriad reasons. The economy could be slowing down. Companies might disappoint on earnings. “Sell in May, and go away?” It works….sometimes.

Other securities have long-term structural challenges, like the US Treasury bond market (TLT). Exploding deficits as far as the eye can see assure that government debt of every kind will be a perennial short for years to come, but not yet.

Once you identify a short candidate, you can be an idiot and just buy put options on the security involved. Chances are that you will overpay and that accelerated time decay will eat up all your profits even if you are right and the security in question falls. All you are doing is making some options trader rich at your expense.

For outright put options to work, your stock has to fall IMMEDIATELY, like in a couple of days. If it doesn’t, then the sands of time run against you very quickly. Something like 80% of all options issued expire unexercised.

And then there’s the right way to play the short side, i.e., MY way. You go out and buy a deep-in-the-money vertical bear put debit spread.

This is a matched pair of positions in the options market that will be profitable when the underlying security goes down, sideways, or up small in price over a defined limited period of time. It is called a “debit spread” because you have to pay money to buy the position instead of receiving a cash credit.

It is the perfect position to have onboard during bear markets which we will almost certainly see by late 2019 or 2020. As my friend Louis Pasteur used to say, “Chance favors the prepared.”

I’ll provide an example of how this works with the United States Treasury Bond Fund (TLT) which we have been selling short nearly twice a month since the bond market peaked in July 2016.

On October 23, 2018, I sent out a Trade Alert that read like this:

Trade Alert – (TLT) – BUY

BUY the iShares Barclays 20+ Year Treasury Bond Fund (TLT) November 2018 $117-$120 in-the-money vertical BEAR PUT spread at $2.60 or best.

At the time, the (TLT) was trading at $114.64. To add the position you had to execute the following positions:

Buy 37 November 2018 (TLT) $120 puts at…….…….…$5.70

Sell short 37 November 2018 (TLT) $117 puts at….….$3.10

Net Cost:………………………….………..………….…………..$2.60

Potential Profit: $3.00 – $2.60 = $0.40

(37 X 100 X $0.40) = $1,480 or 11.11% in 18 trading days.

Here’s the screenshot from my personal trading account:

This was a bet that the (TLT) would close at or below $117 by the November 16 options expiration day.

The maximum potential value of this position at expiration can be calculated as follows:

+$120 puts
–  $117 puts
+$3.00 profit

This means that if the (TLT) stays below $117, the position you bought for $2.60 will become worth $3.00 by November 16.

As it turned out, that was a prescient call. By November 2, or only eight trading days later, the (TLT) had plunged to $112.28. The value of the iShares Barclays 20+ Year Treasury Bond Fund (TLT) November 2018 $117-$120 in-the-money vertical BEAR PUT spread had risen from $2.60 to $2.97.

With 92.5% of the maximum potential profit in hand (37 cents divided by 40 cents), the risk/reward was no longer favorable to carry the position for the remaining ten trading days just to make the last three cents.

I, therefore, sent out another Trade Alert that said the following:

Trade Alert – (TLT) – TAKE PROFITS

SELL the iShares Barclays 20+ Year Treasury Bond Fund (TLT) November 2018 $117-$120 in-the-money vertical BEAR PUT spread at $2.97 or best

In order to get out of this position, you had to execute the following trades:

Sell 37 November 2018 (TLT) $120 puts at………………………$7.80

Buy to cover short 37 November 2018 (TLT) $117 puts at….$4.83

Net Proceeds:…………………..…………….………..………….……..$2.97

Profit: $2.97 – $2.60 = $0.37

(37 X 100 X $0.37) = $1,369 or 14.23% in 8 trading days.

Of course, the key to making money in vertical bear put spreads is market timing. To get the best and most rapid results, you need to buy these at market tops.

If you’re useless at identifying market tops, don’t worry. That’s my job. I’m right about 90% of the time and send out a STOP LOSS Trade Alert very quickly when I’m wrong.

With a recession and bear market just ahead of us, understanding the utility of the vertical bear put debit spread is essential. You’ll be the only guy making money in a falling market. The downside is that your friends will expect you to pick up every dinner check.

But only if they know.

 

Understanding Bear Put Spreads is Crucial in Falling Markets

January 6, 2020

Global Market Comments
January 6, 2019
Fiat Lux

2020 Annual Asset Class Review
A Global Vision

FOR PAID SUBSCRIBERS ONLY

Featured Trades:
(SPX), (QQQQ), (XLF), (XLE), (XLY),
(TLT), (TBT), (JNK), (PHB), (HYG), (PCY), (MUB), (HCP)
(FXE), (EUO), (FXC), (FXA), (YCS), (FXY), (CYB)
(FCX), (VALE), (AMLP), (USO), (UNG),
(GLD), (GDX), (SLV), (ITB), (LEN), (KBH), (PHM)

December 13, 2019

Global Market Comments
December 13, 2019
Fiat Lux

Featured Trade:

(TUESDAY, FEBRUARY 4  SYDNEY, AUSTRALIA STRATEGY LUNCHEON)
(BIDDING MORE FOR THE STARS)
,
 (SPY), (INDU), (NVDA)
(NOW THE FAT LEADY IS REALLY SINGING FOR THE BOND MARKET),
(TLT), (TBT)

Now the Fat Lady is REALLY Singing for the Bond Market

The most significant market development so far in 2019 has not been the wild gyrations of Bitcoin, the nonstop rally in tech stocks (SPY), or the rebound of gold (GLD).

It has been the recent strength of the bond market (TLT), which a few months ago was probing one-year highs.

I love it when my short, medium, and long-term calls play out according to script. I absolutely hate it when they happen so fast that I and my readers are unable to get in at decent prices.

That is what has happened with my short call for the (TLT), which has been performing a near-perfect swan dive since August.

The yield on the ten-year Treasury bond has soared from 2.44% in August to an intraday high of  2.95% weeks ago.

Lucky borrowers who demanded rate locks in real estate financings at the end of September are now thanking their lucky stars. We may be saying goodbye to the 3% handle on 5/1 ARMS for the rest of our lives.

The technical damage has been near-fatal. The writing is on the wall. A 2.00% yield for the ten years is now easily on the menu for 2020, if not 2.50% or 3.0%.

This is crucially important for financial markets, as interest rates are the wellspring from which all other market trends arise.

And while tax cuts are terrible for bonds, they are unbelievably great for stocks. To use Warren Buffet’s characterization, chopping the corporate tax rate from 35% to 21% means your take-home has risen from 65% to 79%, an eye-popping increase of 21.54%.

That means the value of US stocks jumped by 21.54% overnight when the calendar turned the page from December 2017 to January 2018. No wonder the market has gone up every day!

But longer term, and I’m thinking 18 months, rising interest rates trigger recessions and bear markets. So, make hay while the sun shines, and strike while the iron is hot.

Wiser thinkers are peeved that the promised bleeding of federal tax revenues is causing the annual budget deficit to balloon from a low of a $450 billion annual rate last year to $1.2 trillion this year. Add in the bond sales from the Fed’s quantitative tightening and you get true government borrowing of $1.8 trillion for 2019. It will all end in tears.

As rates rise, so does the debt service costs of the world’s largest borrower, the US government. The burden will soar in a hockey stick-like manner, currently at 4% of the total budget.

What is of far greater concern is what the tax bill does to the National Debt, taking it from $20.5 trillion to $30-$40 trillion over the next ten years. If we get the higher figure, then we are looking not at another recession, but a real 1930s style depression rallies.

Better teach your kids to drive for UBER early as they are the ones who are going to have to pay off this gargantuan debt.

So what the heck are you supposed to do now? Keep selling those bonds, even the little ones. It will be the closest thing to a rich uncle you will ever have, if you don’t already have one.

Make your year now because the longer you put it off, the harder it will be to get.

 

 

 

December 10, 2019

Global Market Comments
December 10, 2019
Fiat Lux

Featured Trade:

(MAD HEDGE FUND TRADER ANNOUNCES STRATEGIC PARTNERSHIP WITH TASTYTRADE),
(A NOTE ON OPTIONS CALLED AWAY),
(MSFT), (TLT), (BA), (GOOGL), (SPY)

December 9, 2019

Global Market Comments
December 9, 2019
Fiat Lux
 

Featured Trade:

(MARKET OUTLOOK FOR THE WEEK AHEAD, or THE MELT-UP CONTINUES),
(SPY), (TLT), (VIX), (FXI)

December 6, 2019

Global Market Comments
December 6, 2019
Fiat Lux

Featured Trade:

 

(DECEMBER 4 BIWEEKLY STRATEGY WEBINAR Q&A),
(SPY), (TSLA), (TLT), (BABA), (CCI), (VIX)

November 29, 2019

Global Market Comments
November 29, 2019
Fiat Lux

Featured Trade:

(WHATEVER HAPPENED TO THE GREAT DEPRESSION DEBT?)
($TNX), (TLT), (TBT)

Whatever Happened to the Great Depression Debt?

When I was a little kid during the early 1950s, my grandfather used to endlessly rail against Franklin Delano Roosevelt.

The WWI veteran, who was mustard-gassed in the trenches of France and was a lifetime dyed-in-the-wool Republican, said the former president was a dictator and a traitor to his class who trampled the constitution with complete disregard.

Republican presidential candidates Hoover, Landon, and Dewey would have done much better jobs.

What was worse, FDR had run up such enormous debts during the Great Depression that would ruin not only my life but my children’s as well.

As a six-year-old, this disturbed me deeply as it appeared that just out of diapers, my life was already going to be dull, brutish, and pointless.

Grandpa continued his ranting until a three-pack a day Lucky Strike non-filter habit finally killed him in 1977.

He insisted until the day he died that there was no definitive proof that cigarettes caused lung cancer even though during his war, they referred to them as “coffin nails.”

He was stubborn as a mule to the end. And you wonder who I got it from?

What my grandfather’s comments did do was spark in me a lifetime interest in the government bond market, not only ours, but everyone else’s around the world.

So, whatever happened to the despised, future-destroying Roosevelt debt?

In short, it went to money heaven.

And here, I like to use the old movie analogy. Remember when someone walked into a diner in those old black and white flicks, checked out the prices on the menu on the wall. It says “Coffee: 5 cents, Hamburgers: 10 cents, Steak: 50 cents.”

That is where the Roosevelt debt went.

By the time the 20 and 30-year Treasury bonds issued in the 1930s came due, WWII, Korea, and Vietnam happened, and the great inflation that followed.

The purchasing power of the dollar cratered, falling roughly 90%. Coffee is now $1.00, a hamburger at MacDonald’s is $5.00, and a cheap steak at Outback cost $12.00.

The government, in effect, only had to pay back 10 cents on the dollar in terms of current purchasing power on whatever it borrowed in the thirties.

Who paid for this free lunch?

Bond owners who received minimal and often negative real, inflation-adjusted returns on fixed-income investments for three decades.

In the end, it was the risk avoiders who picked up the tab. This is why bonds became known as “certificates of confiscation” during the seventies and eighties.

This is not a new thing. About 300 years ago, governments figured out there was easy money to be had by issuing paper money, borrowing massively, stimulating the local economy, creating inflation, and then repaying the debt in devalued future paper money.

This is one of the main reasons why we have governments, and why they have grown so big. Unsurprisingly, France was the first, followed by England and every other major country.

Ever wonder how the new, impoverished United States paid for the Revolutionary War?

It issued paper money by the bale, which dropped in purchasing power by two thirds by the end of conflict in 1783. The British helped too by flooding the country with counterfeit paper Continental money.

Bondholders can expect to receive a long series of rude awakenings sometime in the future.

No wonder Bill Gross, the former head of bond giant PIMCO, says will get ashes in his stocking for Christmas next year.

The scary thing is that, eventually, we will enter a new 30-year bear market for bonds that lasts all the way until 2049. However, after last month’s frenetic spike up in bond prices, and down in bond yields, that is looking more like a 2022 than a 2019 position.

This is certainly what the demographics are saying, which predicts an inflationary blow-off in decades to come that could take short term Treasury yields to a nosebleed 12% high once more.

That scenario has the leveraged short Treasury bond ETF (TBT), which has just cratered down to $23, double to $46, and then soaring all the way to $200.

If you wonder how yields could get that high in a decade, consider one important fact.

The largest buyers of American bonds for the past three decades have been Japan and China. Between them, they have soaked up over $2 trillion worth of our debt, some 12% of the total outstanding.

Unfortunately, both countries have already entered very negative demographic pyramids, which will forestall any future large purchases of foreign bonds. They are going to need the money at home to care for burgeoning populations of old age pensioners.

So, who becomes the buyer of last resort? No one, unless the Federal Reserve comes back with QE IV, V, and VI. QE IV, in fact, has already started.

There is a lesson to be learned today from the demise of the Roosevelt debt.

It tells us that the government should be borrowing as much as it can right now with the longest maturity possible at these ultra-low interest rates and spending it all.

With real inflation-adjusted 10-year Treasury bonds now posting negative yields, they have a free pass to do so.

In effect, the government never has to pay back the money. But they do have the ability to reap immediate benefits, such as through stimulating the economy with greatly increased infrastructure spending.

Heaven knows we need it.

If I were king of the world, I would borrow $5 trillion tomorrow and disburse it only in areas that create domestic US jobs. Not a penny should go to new social programs. Long-term capital investments should be the sole target.

Here is my shopping list:

$1 trillion – new Interstate freeway system
$1 trillion – additional infrastructure repairs and maintenance
$1 trillion – conversion of our energy system to solar
$1 trillion – construction of a rural broadband network
$1 trillion – investment in R&D for everything

The projects above would create 5 million new jobs quickly. Who would pay for all of this in terms of lost purchasing power? Today’s investors in government bonds, half of whom are foreigners, principally the Chinese and Japanese. Notice that I am not committing a single dollar in spending on any walls.

How did my life turn out? Was it ruined, as my grandfather predicted?

Actually, I did pretty well for myself, as did the rest of my generation, the baby boomers.

My kids did OK too. One son just got a $1 million two-year package at a new tech startup and he is only 30. Another is deeply involved in the tech industry, and my oldest daughter is working on a PhD at the University of California. My two youngest girls are about to become the first-ever female eagle scouts.

Not too shabby.

Grandpa was always a better historian than a forecaster. But did have the last laugh. He made a fortune in real estate, betting correctly on the inflation that always follows big borrowing binges.

You know the five acres that sits under the Bellagio Hotel in Las Vegas today? That’s the land he bought in 1945 for $500. He sold it 32 years later for $10 million.

Not too shabby either.

40 Years of 30 Year Bond Yields

 

 

November 25, 2019

Global Market Comments
November 25, 2019
Fiat Lux

Featured Trade:

(MARKET OUTLOOK FOR THE WEEK AHEAD, or CATCHING OUR BREATH),
(MSFT), (GOOGL), (TLT), (VIX), (TSLA)