Big Printin’ $TLT: Shaken, Not Stirred

by Dan June 9, 2016 3:15 pm • Commentary

On May 20th we laid out out bullish view for U.S. Treasury bonds, expressing it with a Risk Reversal in September expiration (Must Yield to Fedestrians). Here was the trade an rationale:

TLT ($130) Buy the Sept 126 / 133 Risk Reversal for even money
  • Sell to open 1 Sept 126 put at $2.50
  • Buy to open 1 Sept 133 call for $2.50

Rationale:  This trade offers leverage to an upside move that could have happen quickly in the event of broad market / economic turbulence and offers a decent risk reward without committing to owning the etf at current levels.

Detailed on CNBC’s Options Action:

Two weeks later on June 3rd, after the TLT rallied a few bucks from our entry, we de-risked the trade by covering the short put, and reduced the premium at risk by spreading the long call (TLT Bullish Sept Risk Reversal).

Detailed on CNBC’s Options Action:

Not a bad bit of trading as the initial trade structure was executed for no premium outlay and is now worth $2.75, or about 75% of the gains of the etf since.  But at this point we are fairly comfortable with owning an in-the-money call spread and prefer not to be short downside puts as a means to finance calls or call spreads.  The main reason for this view now is that the trade was meant to fade the growing expectations for a June and July rate increase by the Federal Reserve. Fed Fund futures are now pricing a 0% probability of a June raise, and a 22% chance of a July raise. Any surprises in the next few weeks would cause U.S. Treasuries to tumble, which I don’t think will happen.

But there was a trade that caught my eye today in the market that was fairly similar to our initial trade. When the TLT was $134.32, less than 1% from its 52 week highs made in early February, a trader sold to open 9,000 December 126 puts at 2.39 to open and used the proceeds to buy 9,000 of the Dec 136 / 146 call spreads for $2.59. This entire trade structure cost 20 cents, or $180,000.  On the upside this trade breaks-even at $136.20, offering a max profit potential of $9.80, or $8.8 million. The worst case scenario on Dec expiration is that the TLT is below $126, down about 6% from the trading level and the trader would have losses one for one with the etf, having been put 900,000 shares of stock.

On a mark to market basis, this trade will have losses as the TLT moves closer to the short put strike, and gains as it moves closer to the long call strike.  What’s nice about this trade is that the call spread allows for profit participation far closer to potential losses on the downside, but the trade-off for this is the cap on gains above $146.