Inverted Yield Curve
The Smart Profits Report: Issue #272
Thursday, January 5, 2006
Inverted Yield Curve: Now’s the Perfect Time For LEAPS Options
by Karim Rahemtulla
Chairman, Mt. Vernon Research
A couple of weeks ago, I let you in on Bill Gross’ latest insider buying spree. He was picking up shares of two Pimco floating-rate funds (PFN) and (PFL). Since that communiqué, both closed-end funds have risen nicely. And, since then, Bill has added to his positions in the funds. Both of them have paid a nice monthly dividend for December, as well.
I also took a look at the performance of Pimco’s closed-end municipal funds, which I recommended to you early last year when Gross was loading up on shares of those. They are up close to 20% (PMX, PML, PMF) across the board, including dividends.
So, what does this buying from Gross tell us?
Let’s take a look at the inverted yield curve as well as the type of market his actions are predicting, and then find out how to set up your options portfolio to get ready for it…
Preparing For the Inverted Yield Curve
There is little doubt in Gross’ mind that interest rates in the U.S. are getting close to their peak. He is betting that getting 6.4% tax-free on municipal bonds and 8.4% on taxable funds is a great deal. But, the implications of his buying are much more serious.
If rates do peak in the next few months - the yield curve is almost inverted as I write this - then we are headed for a difficult time.
Low rates usually equate to boom times for the economy, but when short-term rates move higher than long-term rates, this usually means that economic confidence will be short-lived.
In a normal boom cycle, long-term rates should move higher along with short rates. Higher rates in the long-term indicate that borrowing costs are increasing based on the assumption that economic activity should, in the normal course, force the cost of borrowing higher as well. In other words, you should have to pay more to make more.
The current environment is saying that long-term rates are low because they must be low to invigorate a flagging economy. Yet, the numbers from the government suggest that the economy is flying along at 4%-plus annual GDP growth. Something is wrong here. And, the market knows it.
Over time, the bond market has been an excellent predictor of economic cycles. In this case, it is pointing to a slowdown in the months ahead… for whatever reason.
Here’s Where You Need LEAPS To Take Action…
In such an environment, it would be prudent to manage your portfolio in a way that you account for a possible downturn. One way to take advantage of this is to shift some of your capital out of stocks and into LEAPS options.
LEAPS allow you to take much of your dollar risk off the table, while still maintaining upside potential for a period of one, two or three years. In other words, you can put your money into a safer vehicle while still enjoying a higher overall portfolio return… with less risk.
You could also use LEAPS to short certain sectors, like retail and housing - two sectors that will be hit by a consumer slowdown. Or, you could use them to hedge against a general market downturn by buying LEAPS puts.
For example, in my service (see today’s Crib Sheet for details), we recently shorted Tiffany. We bought LEAPS puts for $3.50 ($3,500 for 10 contracts), which gave us the right to sell the shares at $35.
Short Selling vs. Options
If we wanted to “short sell” Tiffany stock, we would have had to put up nearly $40,000 to control the same position. And, if the trade moved against us, we would face potentially unlimited losses, in the worst case. But by owning the options, our worst-case scenario is what we have invested in the options - that is the most we have at risk.
In the LEAPS Options Trader, we make bets on individual stocks and sectors using these options. Right now, we are long gold (and have been for quite a while), short retail, long natural gas (a 17-month play that is about to expire) and long select technology shares.
I make no secret for liking and using LEAPS options in this type of market. After all, if you were faced with day-to-day uncertainty in the U.S. and global markets, would you rather risk 100% of your capital, or 10%?
Good Trading,
Karim
|
Today’s Smart Profits Crib Sheet
- For more on LEAPS, take a look at Smart Profits #165, LEAPS Options Strategies: A Gold Strategy That Beats Stocks, Bullion or Coins, or Smart Profits #173, How to Grow Rich From Your Options Losses.
- Check out our Smart Profits Glossary for definitions of words like “yield curve” or “hedge” found in today’s article.
- The LEAPS Option Trader is a trading service of mine that subscribers use to generate above-average gains, like our recent bull spread winner in Intel. That trade returned a net investment risk of 185%… in about a year. For more information…
Related Articles:
- What Does Bill Gross Know?
- LEAPS Call Option: How to “Swap” LEAPS Call Options For 300% Returns
- Derivatives: Take the Big Guys’ Money With Their Own Weapons
How One Company's Groundbreaking "Cancer Blaster" Could Make You Rich
While the World Health Organization predicts 12 million people will develop cancer in 2009, this little-known company is fighting the surge with its amazing cancer-killing device...
Although most people know nothing about it, this "Cancer Blaster" has already saved thousands of people around the world... Like Ohio resident, Caroline Brubaker, who says "with just three, pain-free outpatient visits, I had my life back" or Richard Swanson of Arizona who ended up cancer-free after just 4 hours of treatment...
The best part is, the company recently discovered an extraordinary breakthrough that could go mainstream in a matter of days... Read the full details to find out how you can get in ahead of the event - and be on your way to booking truly incredible gains.
|
