Bonds have bounded higher alongside the recent stock stumble. The rotation is likely due to a combination of factors, including increased angst over the events in Cyprus and a stock market that was overdue for some profit-taking.
For their part, U.S. treasury bonds had become grossly oversold and were due for a bounce, as my commentary earlier this month suggested.
Click to Enlarge Since then, the iShares Barclays 20+ Year Treasury Bond Fund (NYSE:TLT) has climbed 2.4% and is now testing some key resistance levels. Since peaking in mid-November, TLT has developed a series of lower swing highs and lower swing lows, forming an intermediate-term downtrend. The downward-sloping trendline (black dotted line) has stymied each of TLT’s attempts to reverse back into an uptrend over the past four months. With the past two-week advance, TLT is once again testing this trendline resistance.
Another indicator adding to overhead resistance is the declining 50-day moving average (blue line), which rebuffed two prior advances in December and February.
The current setup in TLT becomes even more appealing when you consider it from a risk-reward perspective. Remember, as traders, we are on a continual search for low-risk, high-reward opportunities. In other words, we seek chart patterns or setups that offer little risk if wrong, but large rewards if right. Consistently playing these types of opportunities allows you to have more losing trades than winning ones, yet still come out profitable in the end.
The risk is small in TLT because if it ends up breaking above trendline resistance, you can exit swiftly, minimizing the loss. On the other hand, if the downtrend continues, it should return to its prior swing low in the $114.60 area, offering a reward that is much larger than the risk.
If you’re looking for a higher-probability strategy to exploit a continuation of TLT’s downtrend, you could sell the April 119-122 bear call spread for 55 cents. To initiate the position, sell the April 119 call and buy the April 122 call. The max reward is limited to the initial 55-cent credit and will be captured if TLT remains below $119. The max risk is limited to the distance between strikes minus the net credit, or $2.45.
To minimize your loss in the position, you could exit if TLT rises above the short strike at $119.
As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.