Playing Devil's Advocate in Bonds

 | Dec 18, 2012 | 12:15 PM EST  | Comments
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There are several macroeconomic reasons to expect the U.S. Treasury complex to continue its decline. Yields are at all-time lows, the economy is slowly stabilizing and, frankly, what goes up must eventually come down. However, timing is everything, and we doubt that this particular selloff is the beginning of the end of Treasuries -- so we are willing to play devil's advocate with the market.

Early in December, the Treasury complex often suffers at the hands of seasonal bearish tendencies, but it tends to find a way to rally into year-end. So far this month, the market has behaved according to historical standards, and we expect that to continue. After all, there is plenty of room for optimism to wane regarding the fiscal cliff, and the chart suggests bonds could be near the bottom of its trading range. In addition, the relative strength index (RSI) oscillator is hovering near the lowest level seen since mid-October, prior to when bonds forged a substantial early-November rally.

Although we are turning short-term bullish in the Treasury complex, it is possible that we'll see another day or so of moderate selling. Accordingly, we are in nibble mode. We like the idea of constructing low-risk bullish positions in the March five-year note futures contract.

Specifically, we recommend purchasing the March five-year note futures contract near 124'05, and also picking up a February 124 put for insurance. The protective put will cost about $250, but it limits the risk of the trade to about $400 on an absolute basis before commissions and fees. While that's the risk, the profit potential on this trade is theoretically unlimited, but we are hoping for a move to the 125 area in this note. If so, the trade could see a profit of anywhere from $500 to $700.

March Five-Year Treasury Bond -- Daily
Source: QST

Along with manageable risk, the margin requirement for this trade is very low -- a few hundred dollars.

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