I mentioned in the CotD from last Friday that I thought TLT implied volatility looked too low. My first instinct was to buy straddles if implied volatility declined, but I’ve modified that idea a bit after watching the price action of TLT, the iShares Barclays 20+ Year Treasury Bond Fund, over the last few days. I still like buying volatility, but I’m going to pick a direction and play for a resumption of the rally in TLT over the next month, for several reasons.
First, the European bank run woes are yet to be resolved, which leaves global investors in search of a safe haven for their cash. That has been the main catalyst for the rally in U.S. treasury bonds over the last 2 years. The situation seems worse now than a year ago, when talk of a breakup of the Euro by politicians was considered taboo.
Second, June options will catch the run-up and investor positioning ahead of the Greek elections, and will expire prior to the next FOMC meeting on June 20th. The idea is to catch the pre-positioning by investors before those events.
Third, the chart of TLT shows extreme strength, even with the 30 point rally in the S&P 500 over the last 2 days. It has worked off the overbought condition with today’s decline, but remains in a solid uptrend, above the 20, 50, and 200 day moving averages.
[caption id="attachment_12239" align="alignnone" width="538" caption="Chart from Bloomberg"]
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Finally, TLT is hovering close to the $125 resistance level of the past 9 months, and any break of that $125 level should be good for a quick 3-5% move higher. So I want to play for a quick move higher. But the call spread makes more sense than an outright call, even if I like buying options, because of inverted skew. Let me explain what I mean.
Most stocks have normal skew. Normal skew simply means that lower priced strikes have higher implied volatility than higher priced strikes. That makes sense as most investors buy lower strike puts for protection or sell higher strike calls for income, and that causes the lower strike puts to have higher implied volatility than the higher strike calls. In certain assets, like TLT or GLD, the higher strike calls are the strikes that investors buy for protection because in certain risk-off scenarios, Treasury bonds go bid or gold goes bid (though not always). As a result, in TLT, I can buy the June 124 call that is priced with a 16.5 implied volatility, and sell a June 129 call that is priced with a 18 implied volatility. I can take advantage of inverted skew, and it improves my risk/reward ratio.
So here’s the trade:
TRADE: TLT ($122.50) Bought the June 124 / 129 Call Spread for $0.95
-Bought 1 June 124 Call for 1.31
-Sold 1 June 129 Call at 0.36
Break-even on June Expiration:
Profits btwn 124.95 and 129 make up to 4.05, max gain of 4.05 above 124.95.
Losses of up to 0.95 btwn 124.95 and 124 and max loss of 0.95 at 124 or below
TRADE RATIONALE:
I get slightly better than 4 to 1 risk/reward to put this trade on and play for the breakout. Given my view that implied volatility is cheap, I should have a couple weeks to adjust the trade without losing much if TLT does not go up immediately.