New Trade – $TLT: Bonds on Steroids

by Dan May 28, 2014 3:13 pm • Commentary

Whether you are an active market participant or just a casual investor, you might have noticed on more than one occasion that conventional wisdom can lose you money.  For years while the Fed was orchestrating their never ending QE, bonds rallied with stocks, with many suggesting that bonds were the bubble, not stocks.  Last spring with the hint of the Fed pulling back from their bond purchases, yields rose like a rocket ship, sporting one of their largest percentage increases in less than a year.  With the Fed’s apparent desire to tighten, coupled with what many economists/strategists/investors feel was an improving domestic and global economy one would have thought that bonds would continue to make new lows while rates rose. Well, as most of you are well aware, from almost the first tick in 2014, investors absorbed the Fed’s taper and for whatever reasons have been buying U.S. treasuries hand over fist sending bonds to their highest levels in almost a year.  To be frank, while I have not been in the camp that the economic recovery in its fifth year of artificially low rates was anything to write home about, I was very much in the camp that if consensus was right about economic growth that bonds would continue to make lower lows.

Using the TLT (iShares 20 year bond etf) as a proxy for bond prices dating back to Jan 2013 prices have once again reached the breakdown level from last spring, that saw a nearly 13% decline to the eventual bottom on December 31st 2013, and capping an almost 20% peak to trough decline from the 2013 highs:

TLT Jan 1, 2013 to present from Bloomberg
TLT Jan 1, 2013 to present from Bloomberg

To say that bond prices may be at an inflection point is an understatement.  As I’ve said before, I do not pretend to have any special skills when it comes to macro trading, but the combination of sentiment, technicals and the low levels of implied volatility of the TLT intrigue me to some degree to make a near term contrarian trade.

If $115 does serve as technical resistance in the TLT then this could be the spot to wade in using options to make defined risk directional bets.  The 5 year chart below of 30 day at the money implied vol (the price of options) in TLT shows levels not seen since the start of QE back in 2010:

TLT 5yr chart of 30 day at the money IV from Bloomberg
TLT 5yr chart of 30 day at the money IV from Bloomberg


For those looking to make near term bet that bond prices reverse on continued improvement of economic data, it could make sense to buy longer dated puts, but sell shorter dated ones to help offset decay. Here’s our trade:

Trade: TLT ($114.78) Buy June 112/July 115 Put Spread for 1.93

-Sell to open June 112 Put at .42

-Buy to open July 115 Put for 2.35

Break-Even on June Expiration: Max profit is at 112 on June expiration with the June calls expiring worthless and the July put profitable. Sideways movement is likely to be a small loser and any move higher in TLT will mean losses. Since this is a vertical strike calendar the best way to analyze this is in delta form. It is currently about -35 deltas, but the June deltas are soft deltas (out of the money) and the July are harder deltas (slightly in the money) Here’s how the structure looks in a payout diagram:

Screen Shot 2014-05-28 at 1.05.05 PM
from TradeMonster


Rationale: This is a safer way to play for a reversal in bonds than simply shorting TLT. The July put is somewhat offset with the sale of lower June puts but it’s still fairly aggressive with around 35 short deltas in the TLT. Any non dramatic move down will work really well. The main risk is TLT continues to climb from here.