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Night of the Living Fed

Eventually the Fed must unwind all its monetary largesse when the economy starts to recover, or we will get the biggest round of inflation this Republic has seen since the phrase "Not worth a Continental" was popular.

Halloween is this Sunday. If you are like me, you are getting tired of all the scary horror movies they show this time of year. It used to be they only played them on the day itself, then it was expanded to 24/7 the entire week before the holiday. Now one channel offers such fare for an entire month before the event. I am ready for Halloween to come and go.

However, one version of the Rocky Horror show will remain even after Halloween. I am of course speaking of the scary game the Fed and Treasury are playing with Quantitative Easing 2. Better known as QE2, it is a game that must end badly. Eventually the Fed must unwind all its monetary largesse when the economy starts to recover, or we will get the biggest round of inflation this Republic has seen since the phrase "Not worth a Continental" was popular. When they do begin to unwind, it will necessarily raise rates and send the recovery into a tail spin.

Until that happens, the Fed will stick to its course and keep buying longer duration Treasury bonds. It is baked in the cake. All that remains is the revelation of the details. The 7-year auction was well received on Thursday so they are being rather successful at supporting Mr. Geithner's financing operations, even if the Fed cannot legally buy the Treasury paper directly. They can buy it next week from the primary dealers at a reasonable mark up for their trouble. The Fed meeting is being held next Tuesday to decide. My bet is that they will only announce something like $200 to $400 billion in new longer-term Treasury purchases. Thus they will dare the market to go down in view of the fact that the Fed will still have some of their announced $500 billion in reserve. Expect that point to be loudly trumpeted.

We also have the back drop of the upcoming elections with a likely Republican control of the House. According to Intrade, the odds are better than 90%. This will likely favor bonds because the Republicans are much less likely to spend money and more likely to try to reduce the deficit. At least that will be the consensus perception for the foreseeable future. To me this suggests a bullish trade on US treasury bonds using the iShares Barclays 20+ Year Treasury ETF (TLT) - Get iShares 20+ Year Treasury Bond ETF Report.

Trades: Buy to open 1 TLT January 101 call for $2.03, sell to open 2 TLT January 104 calls at $1.19 and buy to open 1 TLT January 107 call for $0.62.

The net debit is $0.27.

The net debit of $0.27 is our only investment and maximum risk on this bullish butterfly trade. The maximum possible profit would be $2.73 for about 10 times our investment but that scenario is quite unlikely.

The Greeks for this trade are:

Delta is +.02 so it is a bullish spread. Theta is .0014 so this trade will gain as time passes other things being equal.

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The strategy here is to set our stop profit at a stock price of $104.00 on the TLT ETF. At $104.00, this butterfly will reach its maximum profit so we will exit if that price is touched. I estimate that the probability of the stop profit target being reached to be about 64% based on the past volatility of TLT. The trade should still profit any where between $101.00-$107.00.

At the time of publication, Phil McDonnell held no positions in the stocks or issues mentioned.

Phil is a professional options trader and contributes regular commentary to the Daily Speculations web site. Prior to trading professionally, Phil was a software developer for Dollar/Soft, a financial software company specializing in options software for equities, indexes and futures. He also wrote the book, Optimal Portfolio Modeling, which was published by Wiley Trading in February 2008.

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