Considering Our Options – $TLT March Put Spread

by CC January 27, 2015 12:12 pm • Commentary

I have been pretty clear on this on more than a few occasions, RiskReversal is NOT the place you peeps should go to for in depth diagnosis of the macro goings on in the markets.  We tend to be a bit more micro. But from time to time we find trade set ups keying off of macro events fairly interesting, as we did back in mid December heading into the FOMC’s final meeting of 2014 (read here).  At the time we thought US Treasuries were overbought heading into the event and that we would likely get a near term “sell the news” reaction.  Near term was the key phrase.  We got the sell off and we quickly closed the TLT put trade for a gain.

It is our sense that the U.S. Treasury rally is getting long in the tooth, despite the growing uncertainty in global growth, the surge in the dollar, the crash in industrial commodities and the erratic behavior by a growing number of central banks.  It’s our view that we could be near a period of moderation of Treasury bond demand as we get closer to the ECB’s much anticipated January 22nd meeting and likely decision to get into the QE game.  And I’ll take it a step further, with the next FOMC meeting on Jan 28th, I doubt there will be too many surprises from last weeks minutes of the December meeting, but following meeting on March 18th could be the one where the Fed strikes a more hawkish tone If in the meantime we were to get a continuation of better jobs data (with some wage growth) here in the U.S., improving manufacturing data, stabilization of  commodity prices and the slightest bit of inflation, the talk prior to the March meeting will once again turn to how soon the Fed can raise. Obviously this will not be good for treasuries. I’m not saying this is going to happen. There’s a lot of moving parts here, but options provide a vehicle to express a counter-trend view with outsized potential without too much damage if that trend continues.

I want to make a simple defined risk bearish trades that the yield on the U.S. Treasury bounces back towards 2% in the coming weeks as the ECB grabs the bond buying baton from the U.S. Fed and global investors turn their sites to European bonds as well as a kind of contrarian view that the U.S. Fed gets a tad less dovish in the next couple months.

In the very near term playing for a break of $130 seems fairly logical with a target of $125 (green line below) on the downside, down about 6%. But if you did see the combination of full ECB QE and a more hawkish Fed I suspect you see $120 in the coming months, reversing the last 2 months gains.  I know that sounds like a massive move for a bond etf, but look at the volatility we have seen of late and when you consider the potential impact of full ECB QE, it could prove to be conservative:

TLT 6 month chart from Bloomberg
TLT 6 month chart from Bloomberg

Volatility has spiked with these big swings but it seems justified given the uncertainty about Fed policy and that of central banks around the globe.  That said outright premium purchases are expensive to express directional views, making spreads attractive.

TLT 1yr chart of 30 day at the money Implied Vol from Bloomberg

If we were looking shorter dated we would perhaps try to take advantage of the high IV with a put butterfly but since we’re looking to target March and catch both the ECB and the FOMC we’ll have to pay the high vol for the spread.

TRADE: TLT ($133.70) Bought to Open March 130/120 Put Spread for $2.00

– Bought to open the March 130 put for 2.30

– Sold to open the March 120 put at .30

Breakevens on March Expiration:

Losses: up to 2.00 above 128 with total loss of 2.00 above 130.

Profits: up to 8.00 below 128 with a max gain of 8 at or below 120.

Rationale: We’ve had some success fading some of these break out moves in TLT despite the continued upward trajectory. This is a similar view that could simply be correct despite a large change in the macro picture, as it could simply be overbought temporarily again. But if the trend does reverse, even a slight bit this structure offers an outsized payout possibility.

On CNBC’s Fast Money this past Wednesday I highlighted a large bearish roll in TLT puts in February expiration: