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Thursday, August 30, 2012 - 15:00
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Thursday, August 30, 2012 - 17:33
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Thursday, August 30, 2012 - 15:00

Trade This Inflation Hedge for a Possible 700% Gain

Thursday, August 30, 2012 3:00 PM

Economists don't know if inflation will increase or not, and I certainly don't pretend to know. But like many traders, I am worried about what would happen if inflation picks up. Some traders turn to gold as an inflation hedge and point out that over the long-term, gold has retained its buying power.

One of my favorite examples is that an ounce of gold bought about 350 loaves of bread in 500 B.C., and today gold would buy more than 425 loaves. While this is nice to know, I'm not trading with a 2,500-year time horizon. I need to make money in less time than that.

In the short term, meaning within the next year or so, I think I have found an inflation hedge that will beat gold. If inflation increases even a little bit, then interest rates will go up. This is based simply on the definition of interest rates, which is the amount paid to an investor as compensation for the use of their money after inflation. An interest rate includes a payment for rent on the use of the money, a premium that compensates an investor for the risk of default and protection against inflation.

At least one inflation hedge will fail to deliver that protection. Interest rates on the 10-year Treasury Inflation-Protected Securities (TIPS) have been negative since November. In other words, investors are lending money to the U.S. Treasury at a loss even before considering inflation.

There could be an extended period of deflation, but it is more likely that interest rates on TIPS will move higher. And after nearly nine months of negative rates, they could turn higher at any time. As interest rates move up, the price of bonds falls and that will lead to a price drop in iShares Barclays TIPS Bond (NYSE: TIP), an ETF that tracks TIPS.

There is a precedent for a big move in this ETF. When investors' perception of risk changed during the global financial crisis, TIP fell about 25% in the 2008 bear market.

There is a chance of another global meltdown, and there is a chance of a recession in the United States, and there is a fiscal cliff at the end of this year… and there are many other reasons that investors' perception of risk could suddenly rise.

A specific trigger for a rise in the price of risk could be the November election when fiscal policy might change, which would have an impact on the bond markets. We might also see inflation fears jump if the gains in food and gas prices that the Federal Reserve always calls "temporary price pressures" seem like they will last for the long term.

Instead of shorting TIP to profit from a possible increase in interest rates, we can use a put option on the ETF for a possible gain of more than 800%. With options, we can risk very little for a large potential payoff if TIP falls by 10% before March.

TIP is trading at about $121.12 a share at the time of this writing. A March 2013 put option at a strike price of $112 is trading at about 35 cents. That price is the midpoint of the bid and ask prices, and a limit order at that price has a reasonably good chance of being filled. If TIP falls by 10%, it would be trading at $109.08 and the put option would have a value of at least $2.92, a gain of 734%. Even at twice the price, a 70-cent option would deliver a gain of 317% if TIP falls 10%.

The options are priced so low because TIP has been trading with very little volatility over the past year. Its average true range (ATR) is about 1% of the stock's price. As a point for comparison, the ATR for Apple (NASDAQ: AAPL) is about 4% of its price and the ATR of SPDR Gold Trust (NYSE: GLD) is about 3% of its share price. Low volatility leads to low-priced options.

Another way to trade this would be an inverse TIP ETF, ProShares UltraShort TIPs (NYSE: TPS). This is a very low-volume ETF and traders may find that the TIP March 112 Puts have more liquidity than this ETF.

Action to Take --> While gold is often viewed as an inflation hedge, TIP put options might be a lower risk way to profit from potential inflation. My recommended trade setup would be to buy TIP March 2013 112 puts at 70 cents or less, no stop-loss and set initial price target at $2.92

Amber Hestla does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.