How To Trade Interest Rates

When I tell people that I trade bonds, their reaction is usually, "how boring." But the truth is, after more than 30 years of being a financial market participant, there is nothing that I enjoy working with than bonds.

Granted, there are times when I don't understand why bonds do what they do, but I always trust the bond market. It is Global in nature and trades almost 24 hours a day. Even the effects of attempted market manipulation by the Federal Reserve was short-lived. While interest rates dropped dramatically on certain Federal Reserve announcements, the Treasury markets soon shrugged off fears of intervention.

While many understand bonds to be a less volatile component of a portfolio and because of this "boring," this is no longer the truth. Bond moves have been dramatic in some cases. Double digit gains and losses on certain corporate bonds are not uncommon. You don't need to be a millionaire to win big or lose big in this market though. This is because both interest rates and govenment securities can be traded on derivatives exchanges.





My blogs include charts on both the TNX, the ten year note rate index as well as the futures contract on the 10 year notes. These charts are somewhat inverse of each other because as interest rates rise, notes and bond prices fall. Because of this, you can always find a bull market here. Notice above, the ten year rate is rising, breaking above the 3% level. While you can't go out and tell your broker to buy you 100 shares of TNX, as it is an index; you can trade this index with Options. Options are exchange-traded vehicles which give you the right to buy or sell the TNX at a set price in the future. Thus, you can profit from an increasing interest rate by buying a call option. Because options are rights to buy or sell, the amount of money you put up for this right is a small fraction of the price of the underlying index. Thus, if you are right in both timing and market movement, you can win many times the amount of money you bet.

Another way to participate with the US Government market is through exchange traded futures contracts and options on the futures. What makes futures attractive is that your leverage is further enhanced. To participate in the 10 Year Treasury futures market, your exchange margin requirement is less than $3,000. If you put up $3,000, you can enter into a futures contract representing $100,000 in government notes! Each point that the note futures moves is equivalent to $1,000. Notice the chart below to see how many points a note futures contract can move in a week!

If you are wrong, you can lose your $3,000 AND MORE, very quickly but if you are right, the profit potential is enormous. As such, you should make sure that you only work with risk capital that you can afford to lose. You should also be sure that you have sufficient capital in your account to cover any losses that may result while you are waiting to be right. My rule of thumb is having at least $10,000 in capital for each note position I hold. Having adequate funds available is the key to being successful in the futures market.

Markets being what they are, you can never expect to be right immediately. The market doesn't work that way. Often, one must be patient to realize gains. If your capital is limited though, you cannot have the patience to withstand a move against you. As a result, undercapitalized futures traders usually wind up losing everything. It is the market that generally dictates when they most close their position, usually at the worst possible time.

Boring? I don't think so.

Keep in mind, futures and options can also serve to help you manage your risk. You can use futures contracts with your stock market portfolio to shift your asset allocation without actually buying or selling any additional shares of stocks or bonds. If you fear a market meltdown, you can use the futures market to totally hedge your market position, allowing you to "sit it out" for awhile.

Be wary of those Socialists who bash speculators. Without speculators, there could be NO RISK MANAGEMENT for others. It is the speculators who are willing to take the risk that others don't want. Without them, prices of everything would be higher. Please let the markets work!

Volatility Plays Provide Gains

VOLATILITY THE KEY TO CONSISTENT GAINS

As I mentioned in previous blogs, Volatility is a key indicator that needs constant monitoring. When markets are trending, my volatility measure advances. The rule is to stay with the trend. When Volatility begins to lose strength, there is a good chance that the price movements will lose their magnitude. The move runs out of energy. In times like this, you can take advantage of the lull by selling options. By selling options, you can lock in some of your gain and get paid for the time value of the option. For the most part, you will only see me selling options in my blog. More about this in the future.


BLOOMBERG ARTICLE

“Big currency moves are behind us,” said Maxime Tessier, chief of foreign exchange at Montreal-based Caisse de Depot et Placement du Quebec, Canada’s biggest pension fund manager, with C$120 billion ($98.6 billion) in assets. “The volatility spike has to unwind itself over time. Selling volatility has been the winning trade so far this year and will continue to work well.” Bloomberg article.



READ FUTURE BLOGS

Follow my trades and you will learn what it has taken me 20 years to learn. While there is some "feel" to trading that can only be gained from years of experience, one can easily learn and master the tools needed to time your transaction.

China Worries

Fool Me Once, Shame on You, Fool Me Twice… China Worries

“I’m a little worried…,” Wen Jiaboa, Chinese Premier.

This week, much attention has been directed to the fate of Bernie Madoff, the former NASDAQ exchange director who pulled off the biggest Ponzi scheme in history, defrauding investors of at least $50 billion. But let’s face it, there is still a bigger ponzi scheme in the making and China is now fearful that it will be left holding the bag! As US President Barack Obama continues to spend trying to stimulate the economy and implement his social welfare programs, major investors are only now starting to worry about the “credit worthiness” of the US.

China has reportedly already lost more than $5 billion in other US investments and as of the end of 2008, had become the largest lender to the US owning more than $696 billion in US Treasury securities. Reportedly, China’s investment in US Treasuries is losing 2.7% this year and even the mention of their concern impacted the bond market this week. China wants “guarantees” of their investments and pressed US authorities to manage their financial affairs appropriately.

But as a heavy supply of debt continues to flow into the market, how can high bond prices be sustained? How can we circumvent the basic laws of supply and demand? President Obama tried to assure the Chinese by pledging that the US deficit will be cut in half in four years…

China is stuck. It cannot sell the bonds as even the mere thought of this idea will surely send the bond market plunging (resulting in losses to them). They have no choice but to continue to invest heavily in bonds to keep the market afloat. What else supports the US bonds? Only the government’s ability to tax. Ouch.


At the Heart of Financial Planning

Recently, when asked what I do and I responded that I am a financial planner, the response was, “oh, one of those!” But the truth is, a real financial planner can be more valuable to you now, more than ever. I chuckle each time I see the typical “scare tactics” emerging from the right on how small businesses are going to get hurt due to President Obama’s new tax ideas. People who believe this have obviously never worked with a competent financial planner.

A true, fee-only, financial planner is not going to be selling you investments, insurance or other products, the financial planner is going to review you situation to see if your other advisers are providing competent service that is appropriate to your needs. And most importantly, a good financial planner is going to have a strong command of the tax laws so that you can find ways to manage your taxes more efficiently. Let me make it clear, most financial planners are not CPAs and do not provide tax advice per se. But they should have the expertise to be able to review your taxes and point out strategies that will enable you to reduce and/or defer taxes and possibly eliminate future taxes.

Republican Criticisms
Grassley said Obama's budget proposal to raise taxes, starting in 2011, on individuals earning more than $200,000 and on households earning more than $250,000 will hurt small businesses.
"These small businesses happen to create 74 percent of all new private sector jobs in the United States," Grassley said. "Tell these business owners their taxes will go up. Odds are, they'll cut spending. They'll cancel orders for new equipment, cut health insurance for their employees, stop hiring, and lay people off."
1.
They’ll cut spending. Why??? Seems that all of the business owners that I know spend lavishly on entertainment, travel and other business-related activites so that they won’t have to pay taxes. Being a business owner is a lifestyle, at least being a successful, tax-efficient business owner is.
2. Cancel orders for new equipment. I admit that I don’t know if the rules for depreciation and amortization have been repealed, but business owners and rental property owners strive to take maximum use of such deductions. In 2008, business owners were allowed to immediately expense certain pieces of equipment up to $250,000 (higher limits apply in some cases). You can even write off up to $25,000 on your new SUV! I doubt seriously if such deductions will be changed.
3. How sad that a small business owner who has net income in excess of $250,000 would lay off people and/or cut their health insurance. At some point, business owners need to understand that they have a social responsibility. If you are clearing $500K a year and not taking care of your employees, then you probably should be paying higher taxes. Why should the rest of society be picking up the tab for healthcare for these people when you fully have the resources to provide for them?
4. Tax deferrals through Retirement Plans, Welfare Benefit Plans, Profit Sharing Plans, Volutary Employee Benefit Plans,… on and on and on. The tax planning strategies for business owners go on and on. If you are paying too much tax, then you absolutely need to work with a financial planner. While you may balk at the fee you need to pay, a good financial planner should be able to immediately look at your situation and show you many ways to save money. These savings should far exceed the fee you are paying.
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My Last Concern

The stock market bounced nicely from oversold conditions this week. The market was due for a bounce. Whenever a stock price breaks above or below a major level of support or resistance, it will normally try to come back to that level. I had identified the 7,500-7,600 level on the Dow average as a major support level so for the market to rally back to this level would not be a surprise. Be aware of this market level and be prepared to either improve your current portfolio here (closing out unwanted longs, adding diversification to protect you against any future downside, etc.).

What concerns me the most here is the news that appears to be driving this market move. First of all, as I mentioned previously, I do believe that the market wants to see a resolution to all of the wrong-doing that has been going on. No doubt, Bernie Madoff going to jail was a happy moment for many. Hopefully many more crooks will be identified and jailed but we here at Trendsetter won’t hold our breath.

Other news that sparked the markets was key banks reporting that the are operating profitably. But what does this really mean? Certainly with the billions of dollars that the government has provided them and considering that they aren’t lending out this money, only the biggest spendthrifts would not be profitable. We already caught one spending millions redecorating his office. So lavious expenses are being held in check.

At the end of the quarter though, when banks come out with earnings, sure, they will say that operating expenses were low and that they would be profitable without the massive writeoffs that they may need to take. It’s not that the banks have not been able to run the day-to-day business profitably, the problem is that they made huge, risky bets and shifted lots of it off of their balance sheets. Still, we don’t know how to value these bets since there is no market for it. Well, let me clarify, there is a market but the banks are not willing to recognize the losses.

AND OUR GOVERNMENT…

In their infinite wisdom is again trying to tinker with the market.
Mark-To-Market
Banks want to get rid of mark-to-market while investors and regulators want to keep it. How else can we have any clue what a company is worth? Already investor information is scarce. Public information is reported on a consolidated basis and true fundamental analysis is impossible. Plus, financial information is managed and accounting gimmicks prevent investors from seeing reality. If this were not true, how did we ever get to our current situation? How can investment analysts continue to earn their millions on Wall Street and have missed what was happening?

Already, the government allowed the banks to leverage up to levels way beyond their capacity for risk management. They further extended their exposure by creating derivative products that even the chairman of the Federal Reserve admitted he can’t figure out. And now the banks want us to value these items at full value?????? Avoid bank stocks unless you just like the action.

ON THE BRIGHT SIDE

Our diversified 2009, $100,000 portfolio closed the week with a value of $102,475. Our cash reserve still remains at a little more than $43,000 Our most recent recommenation of Kohls Department Store closed at 38.22 on Friday. We purchased it at the open on the Monday, March 2, following our recommendation at $34.80.

10-Year Note Futures Options


Our Treasury Note option trading won more than 3% on each $10,000 unit this week. Note that the April 124 call position is still open and marked-to-market at Friday’s close.



As the stock market increases, bond and note rates have been rising. We expect volatility however to remain confined between the two trend lines noted on the chart above. The high point is 3.38% and the low point is 2.76%. While volatility diminishes, selling options enables one to reap generous short-term gains.

Prepare for January Test of the Lows

7 January 2009

The trading year 2008 has finally come to an end and the new year has started off well for stocks. But what can we expect going forward and what are the best ways to make money?

The chart above is a long-term, monthly chart of the Dow Jones Industrial Average. We can clearly see that there should be strong support at the solid horizontal line just below the 8,000 level. Stock market technicians may quickly recognize this level as the “neckline” of a head and shoulders top formation. With the Dow average trading at 8,800 this morning, I suspect that despite a strong start to the market this year, it will eventually turn negative and seek this level below 8,000.


SUPPORTING THE DOWNTREND

One of the key indicators in my work is the volatility levels of the price action. The following chart indicates that monthly volatility for the Dow Jones Average has been rising sharply each month and, in fact, is at the highest level seen in over 20 years. When this indicator is rising, it is wise to stick with the trend. Only when this indicator reverses and starts falling can one have some reasonable assurance that the current trend may be coming to an end.

POSSIBLE SUPPORT IN JANUARY

Molson Coors (TAP). The chart above is reflective of a large number of stocks that I follow. Stocks have risen for the past two months, many touching a resistance level in the form of a moving average. While most are only touching the 4 month moving average, Molson Coors has surpassed the four month average to touch the 10 month average.

When stocks rise, as they have over the past two months, they inevitably will pull back trying to find support. Usually, support happens over three periods. Thus, I am always looking for a three period test of the low. In the case of Molson Coors. The monthly low price occurred in October at 37.36. It rose in November and reached its peak in December at 49.89. Expect this stock to fall back. I would begin taking a position at 43 but if the market is very weak, expect a test of the 37 level.

I expect a number of other stocks to make the 3-month test of the low price in January. As a result of this overview, I expect stock prices to be weak this month.

Still, there are many opportunities in the market where you can make money regardless of the market move.



SUPPORTING THE DOWNSIDE

Ultra Short Dow (DXD). We purchased shares of DXD in our 2009 portfolio at the close on 12/31. Many investors lost heavily in 2008 not because of a lack of diversification in their portfolios, they lost because everything they owned went down. True diversification consists of assets that are not positively correlated. Had you been correctly diversified, your investment manager would have made sure that some of your positions were going up while others were going down providing you with a moderate return.

As both stocks and bonds rose and then fell together, many portfolios suffered heavy losses across the board. One way to manage a portfolio is to include shares of ProShares short or ultra short products. Reviewing both the S&P 500 and Dow Jones Industrial averages, at the end of the year, I felt that the S&P could fall around 6% while the Dow could fall 11%, reaching perhaps the 7,500 level. Thus I chose to include DXD in my portfolio. When it appears that the market has bottomed and found support, this position will be reduced or totally removed but for now, it stays as there are still heavy downside market pressures that will come to light soon.


BOND BUBBLE

Proshares Ultra Short 20 Year Treasury (TBT). The US Federal Reserve has been pushing interest rates down as a way to enhance liquidity in the financial system. US Congress and the Executive Branch have been spending furiously trying to preserve the banking system and most recently, the auto industry. Trillions of US dollars have already been spent and the new president has indicated that Trillion Dollar Deficits are likely to be seen for years to come. Despite the level of debt currently taken on by the US and the more debt that is likely to come, it’s beyond belief that investors could be happy buying US debt that pays virtually no interest! While the US will do everything it can to preserve the dollar and maintain steady interest rates, at some point, foreign governments who are currently buying billions of US debt are going to start thinking twice. In my world, when I incur more debt, my interest rates go up. At some point, investors are going to realize that they need to get returns for their investments. Rates will rise, bonds will fall and the dollar will most likely be under pressure. I recommend steady buying of TBT at these current low rates. This should be a core holding in your portfolio.



WEAK DOLLAR AND OIL

Crude Oil Total Return (OIL). An easy way to play oil. Who hasn’t heard that the price of crude oil has fallen from $147 a barrel to under $40. While the price of this exchange traded instrument isn’t the same price as a barrel of oil, it does track the price quite well and enables investors an easy way to participate in the oil market. After a nice rally, oil appears to be dropping but don’t wait for lower prices to appear. While demand is still weak, start building a position and buy more should prices fall. This also should be a core holding as a weak dollar will affect the price. Eventually, an improved economy will stimulate prices and OPEC’s constant manipulation with prices will also result in eventual higher prices.


GOLD

Another good way to protect yourself from the effects of the falling dollar is to own GOLD. While gold and silver coins have been hard to come by lately because of hoarding, there are other options that investors can utilize to maintain a position.

GLD is a Gold Trust that tracks the price of gold without the inconvenience of actually owning to precious metal. I recommend taking positions in this entity but at lower prices. As the chart below indicates, GLD experienced a topping formation over the past two weeks and began falling. We will be adding positions of GLD as well as Barrick Gold (ABX) to managed portfolios at lower prices. You should also maintain a precious metal position in your portfolio. A lower priced stock that has been moving well with precious metals prices is Silver Wheaton Corporation (SLW).


HOW TO BEGIN MAKING MONEY NOW!!!

While these positions should help you to build a healthy portfolio that will stand up to the worst news the economy can bring, there are other tactics that I am employing now to provide solid returns while having reduced risks.

As seen earlier in the newsletter, VOLATILITY LEVELS are at all-time highs. Those who follow the stock market closely are familiar with the VIX, a volatility index for options on the S&P 500 index.

The above chart shows the VIX index on a daily basis over the past year. Notice how dramatically higher this index rose when the stock market was falling. This index denotes fear and it indicates the premium that investors are willing to pay for portfolio insurance. And while the index has fallen substantially from its highs, high levels of volatility remain in today’s market.

While most investors wish to avoid volatility, in today’s market, this is virtually impossible. Here is a way that you can use volatility to help you generate a good return from your investments while managing your risk.


THE BUY/WRITE STRATEGY

This strategy involves buying a stock and also selling an option related to this stock. What is a stock option? It is the right (but not the obligation) to buy or sell a stock sometime in the future at a specific price. Call options give the buyer the right to purchase a stock at a given price by a certain time in the future. A Put option gives the purchaser the right to sell a stock at a given price at some time in the future. For this right, the purchaser pays the selling a premium. Since premium levels are very high now, you can receive this premium amount to help define your risk and return in an investment strategy. I recommend that 40% of your portfolio at this time consist of this type of strategy.

For our 2009 portfolio, we established buy/write positions in AMR, BB&T, JB Hunt, Potash, Teva and Occidental Petroleum. I will illustrate the workings of the AMR strategy to show the benefits that such a strategy can bring.

On December 31, we purchased shares of AMR at 10.30 and sold a January 2010 10 call at 4.20.

The long term monthly chart of AMR shows that the stock dropped to $5 a share but appears to be making a base. Just buying the stock at $10 seems to be a good long term opportunity considering that the stock has been up to the $40 level twice in the past ten years. But for the moment, and with your money, I prefer to be a little more conservative. In this case, I bought the stock for $10.30 but also sold someone the right to buy the stock from me at $10. I will lose $0.30! But, for that right, the speculator paid me $4.20.

As the table above illustrates, we paid out $10.30 for the stock and received $4.20 for the option. Our net cash outflow is $6.10 or $6,100 for 1,000 shares. In January of 2010, should the stock be at or above $10 per share (it currently looks like an easy bet), the speculator who paid us $4.30 for the right will take the stock from us at $10 a share. Not including commissions, our gain per share is $3.90. As our cost per share was only $6.10, our percentage gain is nearly 64%. Since this transaction occurred at the end of December, 13 months remained so our annualized rate of return comes to 59%!

Sure, the stock could be at 20 or 30 next year should the markets turn around. If that is the case, then this strategy would appear to be foolish. But the strategy not only provides a substantial return for the next year, it also provides us with considerable downside protection should the market decline. AMR could fall to 6.10 before we would have a paper loss on our investment. But what is the worst outcome? We would now own AMR at 6.10 a share and would be free to again sell option premium for the next year out if we choose.

The stocks that I chose for our initial 2009 positions all provided at least a 20% potential gain with downside protection of at least 33%. If the overall market (and our stocks) dropped 33% next year, we would be at break-even (while your friends are suffering through the second heavy year of losses in a row).

Trendsetter is produced by Gary Lewis, CFP® and is intended to be of an informational nature only. Recommendations mentioned in this writing should be implemented only after reviewing your specific situation with your investment adviser or financial planner. Also, prices used in this publication change and could be very different than reflected here. Gary Lewis and his clients may own investments mentioned in this newsletter.

Gary Lewis’ portfolios take advantage of his more than eight years experience working as a specialist in the deriviatives industry and over 30 years working with investments. He specializes in designing portfolios that meet the client’s required rate of return with a minimum of volatility. Using a comprehensive financial plan as a starting point, Gary helps you to determine your action plan. If you wish, Gary can help you implement the plan so that you can achieve your future financial goals.

In addition to holding the Certified Financial Planner (CFP®) certification, he also holds the Chartered Financial Consultant certification (ChFC) and has earned an MBA in Finance from Northwestern University. Gary currently resides in Mexico City.

For more information, contact him at gary@assetdesigncenter.com.