Ian Cooper’s Options Trading Pit newsletter is out with a new ad, in a letter from Brian Hicks, that tells us that the biggest investment bubble is about to explode … and that Ian’s got the trades to tell you about that will help you profit from this explosion.

They don’t hide the “bubble” they’re talking about — that’s not the tease today — they just tease us that they’ll share the best trade to profit from this bubble’s burst, but only after you subscribe to this options trading service (it’ll cost you a “discounted” $799, FYI).

So what is the bubble? It’s the bubble in US Treasury Bonds, as you might have guessed. There was a short time, during the heat of the panic, when short term treasury debt even traded with a negative yield, meaning that at least one person was willing, albeit briefly, to pay the US government to hold his money for him.

For those who are unfamiliar with bonds, we’re talking here just about the sovereign debt of the United States — the bonds issued by the Treasury Department. They are sold in many different loan periods (3 month bills, 10 year bonds, etc.), and are considered by most people to be the only truly risk-free investment (at least, free of risk of default), because they are backed by the tax-collecting ability of the United States. Interest rates are extremely low right now, which is quite handy because the government is going to have to borrow a lot more money to help finance bailouts and keep the government running as tax receipts dip in this recession.

There are a few main reasons (in my opinion) why many folks believe that US government bonds will see this bubble burst as they fall in value (which would mean that interest rates are going up — the bond’s price moves opposite the interest rate).

First is that foreign governments will stop buying these bonds — a growing percentage of treasuries are in foreign hands right now, particularly in the hands of large exporters like Japan and China. If they stop buying (or worse, start selling), because they have less money now, too, the demand will drop and prices will have to drop (meaning yields go up) to bring in more demand. Of course, if they do this and bring prices down then their massive portfolios of these bonds lose value, too.

Second is that supply is increasing dramatically with the expectation of trillion dollar deficits this year and in the near future. And if supply increases without an increase in demand, again, the price will have to drop to bring in more demand.

And third is that the inflation picture might change dramatically in the near future. While we’re currently experiencing some “disinflation” and the Federal Reserve is fighting the prospect of deflation, the inflation hawks and gold bugs believe that the Fed’s attempt to increase the money supply will lead to inflation, and possibly to hyperinflation. Bonds are great investments in deflationary times, but they are awful to own if inflation takes off (except, arguably, for inflation-adjusted bonds).

The ads say that “This next bubble isn’t just going to pop… it’s going to explode,” using as examples some previous bubbles (real estate and internet stocks). Maybe so.

Here’s a little hint of the hyperbole for you:

“Ian – the man who called the sub-prime collapse back in February 2007 – has just issued his latest – and MOST URGENT – warning:

“‘The U.S. Treasury bubble–very soon–is going to burst wide open.’

“And as the Treasury bubble explodes, Ian and his small but wildly successful group of investors will be getting rich… by effectively shorting the U.S. Government… taking lightning-fast profits on the order of 86%… 138%… 140%… and 220%.

“Here’s how it’s going down:

“As you know, Ben Bernanke, Henry Paulson and the boys at the Fed and Treasury are flooding the financial system with cash. They’re slashing interest rates… and they’re bailing out seemingly every big corporation that raises a hand.

“It’s almost as if Bernanke and Paulson are openly begging for inflation.”

So that’s part of the argument — the ad also goes on to say that the next big leg down for the economy will begin in April, 2009, and that this will allow for a second opportunity to profit from these strategies. That time period argument is based on the schedule for mortgage resets, with apparently a large number of them scheduled to reset, particularly option ARMs, starting in that month. While it’s anyone’s guess how federal policy on foreclosures might impact this, and the problem has probably mutated somewhat with the new policies we’ve already seen and with the already strong wave of foreclosures, the date is real, and folks have been looking at this date as the start of a new foreclosure wave for some time. There’s a good article from BusinessWeek about it from last Summer, if you’d like more detail.

Of course, the bubble in Treasuries is an oft-discussed topic in the financial press — you’ll see any pundit worth his pinstripes talking about the bubble in T-bills, or at least suggesting that they should be avoided and that the only reason anyone holds US government bonds right now is because of a “flight to safety.” Ian may well be right on this, and his newsletter may provide useful advice otherwise, but it’s certainly not an idea or a concept that you require an investment newsletter to comprehend.

One of the best articles about this came out in Barron’s a few weeks ago — on January 3, a day before Ian apparently issued this advice to his subscribers. The Barron’s article is here (I think non-subscribers should still be able to access that link, sorry if I’m wrong) if you’d like a good overview of the situation, which hasn’t changed all that dramatically in the weeks since (the article is dated Monday, January 5, but Barron’s actually comes out on Saturday morning on the weekend preceding the publication date, Ian’s advice came out, so his ad says, on Sunday).

As Barron’s says, and as most pundits seem to agree, it’s quite difficult for an ordinary investor to “short” Treasury bonds, (that is, to borrow them, sell them now, and hope to buy them back at a cheaper price to repay your loan in the future, as you can easily, though at some risk, do with most individual stocks). With the advent of Exchange Traded Funds for a few debt indexes, however, you can bet against US government debt using put options or short ETFs.

I’m neither an options specialist nor a bond trader, so I don’t know what the best or safest way to trade this idea of a “bursting bubble” in Treasuries would be, but here are a couple examples:

The main short ETFs that can be used to bet against these bonds are the UltraShort 7-10 year Treasury (PST) and the UltraShort 20+ year Treasury (TBT). Each aims to return 2X the opposite daily return of its respective index (the Barclays Capital indices, which many people still refer to as the Lehman bond indices). It’s worth being cautious with these UltraShort ETFs, even if you like the idea of leveraging a bet against these bonds — many UltraShort ETFs have done a reasonable job at hitting their target on a daily basis, but over time the leverage impact has made them perform wildly differently than their underlying index on a long term basis, some of these short ETFs have even lost money in the long term when their indices have fallen, the opposite of the result that you’d expect. Here’s a pretty good article about the unexpected results that some longer-term holders of these ETFs would have seen last year.

Perhaps a cleaner and more predictable way to make this bet, though it might cost a bit more, is by buying puts against an ETF that tracks these bond indices. This is also likely to be closer to what Cooper recommends, since it’s an options trading service. You can go to iShares to see all the government bond index ETFs they provide for various time periods (they also have other fixed income ETFs for other sectors, like agency bonds, etc.).

Most of these ETFs have options available, so you can simply choose a date in the future when you think they will have fallen further (the farther out you go, the higher premium you’ll pay) and buy a put option that gives you the right to sell that ETF before the expiration date at a set price. If the ETF falls faster than other options traders are expecting, the premium might rise so you can sell it back for more money … or if the ETF actually falls below the strike price you bought (by more than the amount you paid for the option) then you should almost certainly be able to make a profit by selling or exercising the option (people almost never exercise options, which would mean in this case that you buy the ETF at a lower price and sell it to the other party in your options transaction at your agreed-upon higher price).

You can also, if you’re trying to really leverage your bet, buy call options (the right to buy at a price, instead of sell at a price as with puts) on one of the UltraShort ETFs. This is something that’s often best left to day traders and cowboys, but if you’re right and trade nimbly this would offer the highest potential returns (and the greatest potential to lose your investment, of course). Since Cooper is promising fast and high returns, it’s quite possible that this is one of the possible recommendations he’ll be making.

I know probably many of you out there in Gumshoe Land have done similar trades, or used similar tools, so please feel free to flesh in these ideas with a comment below.

I’d agree that the likelihood of Treasury bonds being this expensive in the years to come seems very slim, but I have no idea when the “flight to safety” might end … and though I also expect we’ll see inflation return, I can’t discount the possibility that we’ll see possibly an extended period of deflation first … but really, to tell the truth, I have no idea what’s going to happen with these bonds that trade based on so much more than simple inflation expectations. Buyer beware, and make sure to become well informed if you decide to pursue any of these strategies.

Happy investing, all!