Earlier today we laid out some thoughts on how we are considering managing our winning trade in TLT. As we consider 2 events, the ECB’s rate decision tomorrow, and U.S. jobs data Friday morning, and having no idea how equities and bonds will react we are going to close this position after capturing such quick short term gains and look for a better re-entry. I will add that one of the main reasons we entered the trade last week was what felt like overly optimistic sentiment, and the etf approaching key technical resistance at $115. Since then, the price action has caused many to go the sidelines in the near term on bonds, and the etf is now just above near term technical support at its 50 day moving average at $111.14 (circled):
So we are going to exit the position and let the data fall where it may, as greater volatility in the very near term is not likely to yield too much more potential profit and a sharp rally could clearly erode existing gains.
Action: TLT ($111.56) Sold to Close June 112 / July 115 Put Spread at 2.93 for a 1.00 gain
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Previous Post June 4th, 2014: Considering Our Options: $TLT June/July Put Spread
Last week we took the view that U.S. Treasuries (using the TLT as a proxy) had probably come too far too fast in the near term and wanted to make a define risk trade that the enthusiasm would abate at key long term technical resistance. We expressed the near term bearish view using diagonal calendar structure that protected against decay but in a way that left the trade fairly short delta on a move to our short strike. Since that time, the stock is down to the short strike so it’s a good time to re-evaluate and consider our options for trade management. To recap, here was the trade from last Wednesday:
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
TLT is now 2.7% lower at $111.66 in a week, a fairly big move for bonds in such a short period of time, and the structure is currently worth about $2.85.
The structure is short about 25 deltas here (after starting short 35 deltas) so the trade profits if TLT keeps going down but the rate of change of those profits diminishes the farther down TLT goes as the front month and back month strikes both approach 100 deltas at which point the trade has reached maximum profit potential. The sweet spot that we’re looking for is actually here at 112 as the front month option can expire worthless with the July puts profitable and able to be spread or have the calendar rolled.
While the trade has less delta than it had at initiation, the trade structure is now more positive decay, meaning we have time on our side since the we are at the June 112 strike, which will decay more quickly than the July 115 put. If TLT was to stay around here until June expiration, the June 112 put that we are short would expire worthless, and we would be long the July 115 put that would still have $3 of intrinsic value and a month of time value remaining. Of course, that’s the ideal scenario, and TLT is unlikely to do exactly what we want it to do. Our main risk here is a big move higher in TLT, back to $114.50 or above. At that point, while the June 112 put will quickly move to 0, our July 115 put will lose value rapidly as well. However, as long as TLT remains below $113.50, we’re comfortable with a bounce since the short June put should offset most of the losses to the July 115 put.
A move above 113.50 might have us reconsider simply watching and waiting, but for now, we like the position right here.
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New Trade – $TLT: Bonds on Steroids
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:
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:
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:
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.