Wednesday, September 22, 2010

Establish ProShares UltraShort 20+ Year Treasury ETF Covered Calls

A new covered calls position was established today in the Covered Calls Advisor Portfolio(CCAP) with the purchase of ProShares UltraShort 20+ Year Treasury ETF (TBT) covered calls. TBT was one of the covered calls positions that was called away last Friday at Sep2010 options expiration and today it was decided to re-establish a new position for the Oct2010 expiration as follows:

Established ProShares UltraShort 20+ Year Treasury ETF (TBT) Covered Calls for Oct2010:
09/22/2010 Bought 300 TBT @ $31.75
09/22/2010 Sold 3 TBT Oct2010 $32.00 Calls @ $.94

TBT seeks daily investment results, before fees and expenses, which correspond to twice the inverse of the daily performance of the Barclays Capital 20+ Year U.S. Treasury index. The fund normally invests at least 80% of assets to investments that, in combination, have economic characteristics that are inverse to those of the index. It also typically invests in taking positions in financial instruments, including derivatives that should have similar daily return characteristics as twice the inverse of the index.

This investment is based on the fact that current long-term treasury yields are near an all-time low -- as such they are likely to revert-to-the-mean and be substantially higher than their current levels in the future. The current high stock-to-bond yield difference in combination with the present, albeit modest, economic recovery should begin to reverse recent downward pressure on rates and begin to push Treasury yields higher during the next several months. Also in this regard, widely published fears of a double-dip recession are excessive. The present relatively high Treasury yield curve as well as the increase in the Conference Board's leading economic index over the past six months portends an extremely low likelihood of a double-dip recession.

Another indicator that the Covered Calls Advisor follows closely with regards to interest rates is the Money Multiplier, which is defined as the M2 Money Supply divided by the Fed's Monetary Base. After a precipitous decline from Fall 2008 to early 2010, this indicator bottomed at 4.05 in February 2010 and has begun to rise again (albeit slowly) to its current level of 4.36. Additionally, M2 has increased at a 3.6% annualized rate during the past 3 months versus a 1.9% increase over the past 12 months. If this increasing velocity trend continues, both overall economic activity and interest rates are likely to also move higher.

The Federal Reserve Board and also Congress will have some influence on the ultimate deflation/inflation outcome. For their part, the Federal Reserve has recently indicated that they might use further quantitative easing to prevent deflation. This advisor believes that the Fed will decide that approach will not be necessary since the pace of this recovery is actually slightly better than that of the past two recessions (See Link). Rather, the Fed will more likely begin to gradually support their higher inflation target. As for Congress, Warren Buffett said it best in his "The Greenback Effect" editorial in the New York Times almost exactly one year ago: "Legislators will correctly perceive that either raising taxes or cutting expenditures will threaten their re-election. To avoid this fate, they can opt for high rates of inflation, which never require a recorded vote and cannot be attributed to a specific action that any elected official takes."

In short, for the reasons described above, this advisor believes the interest rates pendulum has now begun a swing back from the past three decades of rate declines, and will soon begin to reverse in the direction of future increases in both inflation and interest rates.

Some readers will ask: Why establish an out-of-the-money position in an inverse ETF instead of simply an in-the-money position in a direct investment (such as TLT)? In short, an out-of-the-money position in the inverse TBT ETF enables for the possibility of capital appreciation in the underlying ETF and thus a substantially higher potential return-on-investment than could be achieved from an in-the-money TLT position (since in-the-money covered calls positions eliminate the possibility of capital appreciation in the underlying equity) if interest rates do in fact trend slightly higher.

Two possible overall performance results(including commissions) for the TBT transactions would be as follows:
Stock Purchase Cost: $9,533.95
= ($31.75*300+$8.95 commission)

Net Profit:
(a) Options Income: +$270.80
= 300*$.94 - $11.20 commissions
(b) Dividend Income: +$0.00
(c) Capital Appreciation (If TBT unchanged at $31.75):
-$8.95 = ($31.75-$31.75)*300 - $8.95 commissions
(c) Capital Appreciation (If TBT exercised at $32.00): +$66.05
= ($32.00-$31.75)*300 - $8.95 commissions

Total Net Profit(If TBT unchanged at $31.75): +$261.85
= (+$270.80 +$0.00 -$8.95)
Total Net Profit(If TBT exercised at $32.00): +$336.85
= (+$270.80 +$0.00 +$66.05)

Absolute Return if Unchanged at $31.75: +2.7%
= +$261.85/$9,533.95
Annualized Return If Unchanged (ARIU) +41.8%
= (+$261.85/$9,533.95)*(365/24 days)

Absolute Return if Exercised at $32.00: +3.5%
= +$336.85/$9,533.95
Annualized Return If Exercised (ARIE) +53.7%
= (+$336.85/$9,533.95)*(365/24 days)

Downside Breakeven Price Point: $30.81
Downside Breakeven Protection: 2.7%