Five-Year T-Notes Still Look Like a Short Play - TheStreet

Sometimes you can be too early on a trade. But in order to maintain consistent results, it's best to trade every setup that gives you an edge, even at the risk of being too early.

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Losses are a part of trading. Nobody can predict the future with certainty, and you can never be 100% certain which of your trades will come out winners. That's why you've got to take every trade that conforms to your definition of a trading edge.

In this regard, it may be instructive to review the anatomy of a recent loss I sustained when trading the June five-year Treasury notes (FVM2: CBOT).

Last Thursday I

suggested that the Evening Doji Star (i.e., a gap up in which the open and close are the same) in the June five-years was indicative of a top in this market, but that traders would likely be uncomfortable initiating or holding short positions, given the upcoming holiday and the recent round of official warnings about the threat of terrorist attacks.

The reluctance of traders to short debt instruments was evident as the fives rallied to a new contract high during Thursday's session (see the daily chart below).

Still, the lack of short-sellers going into the weekend didn't stop me from shorting the Doji pattern during Thursday's session. This pattern setup has provided a consistent edge and many winning trades. At a contract high, the pattern also presented a high reward-to-risk trade. Second-guessing trade setups, or any other consistent trading edge, is akin to saying you know more than the market, and that you know which trades are going to work out for sure and which ones aren't.

Playing the Doji

One of my goals in trading is to employ intraday risk with the aim of reaping daily or weekly rewards. On Thursday, five-year notes gapped lower on the opening but rallied to Wednesday's close, creating a cross of the Doji, which usually provides strong resistance.

My objective once a market hits the level of the cross on an Evening Star Doji is to short against it every time it hits. Five-year notes left a tail on the five-minute chart. That's where I initiated my short -- at the 106-225 level. I would know the trade was not working out if the market traded above the high of the Doji, to a new high, above 106-250. My stop got elected just above that level, taking me out of the market for a small loss.

Reward and Risk

Let's review the risk-to-reward profile for this trade. The initial profit target was 106-015 on the basis of the current structure of the market, yielding an approximate 5-to-1 reward-to-risk ratio (a 42-tick reward divided by an eight-tick risk. The five-years trade in 64ths, with each 0.005 tick, or 64th, valued at $15.63). The 50% retracement of the March low to the May 21 high at 105-060 (or lower!) stood out as a compelling secondary objective to hold at least part of the position if the Doji truly represented a top reversal.

Where does this leave us? Thursday's (May 23) action in the June five-years effectively left a tail bar that closed below the Doji, another bearish sign that makes the current setup continue to look like a top. On Friday (May 24), the fives left another Doji, this time with a lower high and lower close than the previous Doji, leaving the reversal setup and downside objectives intact.

Meanwhile, the underlying fundamental reasons to be short debt instruments also remain. This week the government will sell a record $27 billion worth of two-year notes. Heavy supply in the twos should spill over to pressure prices in the fives. Although inflation appears subdued, situations in which short-term interest rates (1.75%) are below GDP growth (

preliminary numbers for the first quarter were 5.6%) have historically been inflationary.

Any positive economic news increases the odds the

Fed

will tighten monetary policy. Indeed, the September federal funds futures contract (FFU2: CBOT) is pricing in an 82% chance the Fed will raise its target rate to 2% from 1.75% by the end of the summer. The December fed funds contract suggests rates will increase to 2.50% by Christmas. Rising government debt, the specter of inflation and monetary tightening are all negatives for Treasury futures.

June 30 is the roll date for T-bonds and notes, when they become the front-month or next most-actively traded contract. Traders planning to short debt futures and hold them for more than a few days should trade the next front-month contract, September. This setup also applies to the September five-year note contract (FVU2: CBOT).

More Dojis

If you're looking for another market with a similar setup, check out the euro FX (ECM2: CME) and Swiss francs (SFM2: CME).

Notice that both are also in

weekly

tail formations at a double top. Combined patterns are stronger than any individual pattern.

Updates

In other markets,

July sugar (SBN2: NYBOT) is still a pullback that has held at the 61.8% and 38.2% confluence of two prior swings, providing a defined-risk long opportunity.

The June

Australian dollar (ADM2: CME) is in day two of a pullback. Monitor this momentum market for a long entry, or for adding to positions once it trades above the high of the low bar in the pullback starting last Wednesday.

The energy complex is breaking down: July crude oil (CLN2: NYMEX), unleaded gasoline (HUN2: NYMEX), heating oil (HON2: NYMEX) and natural gas (NGN2: NYMEX) all hit 10-day lows on Friday.

Marc Dupee is an independent trader and co-author of the book

The Best: Conversations With Top Traders. Dupee was formerly markets analyst and futures editor for TradingMarkets Financial Group. At time of publication, he was short the June five-year Treasury notes, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While he cannot provide investment advice or recommendations, he invites you to send your feedback to

Marc Dupee.

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