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The Latest Bond Surge Will Peter Out

Here's how to play TLT's mean reversion


The degree to which last week’s poor employment report spooked the markets is perhaps best illustrated by the enormous surge in the popular iShares Barclays 20+ Year Treasury Bond Fund (NYSE:TLT). Friday’s flight to safety led to a 2% jump in TLT, driving it to extreme heights in the short run. Alongside soaring bond prices, the 10-year bond yield fell to its lowest levels of the year at 1.69%.

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To capture just how overbought TLT has become, I’ve plotted a Bollinger Band study set at three standard deviations. Over the past few years, it’s been rare to see TLT venture outside the three sigma bands. Yet with Friday’s up-gap, it did just that.

While the bond fund could continue higher from current prices, it’s much more likely we see it mean-revert or tread sideways to work off the overbought conditions.

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Candlestick analysis helps add color to our short-term outlook. Friday’s trading session ended with an exhausted-looking shooting star candle. Not surprisingly, the candlestick looks just like its name — a shooting star. It has a small body at the lower end of its range with a long upper shadow. When the candle forms after a multi-candle upswing — as it has in TLT — it often indicates a pullback is imminent.

At a minimum, the current posture of TLT makes bullish plays unattractive. If you think the uptrend in bond prices is going to return with a vengeance, at least wait for a better risk-reward entry. A pullback or some consolidation will develop just such a setup.

On the flipside, if you’re willing to bet TLT falls back from its lofty heights, you could consider buying a May 123-120 bear put spread for $1.50 or better. The max risk is limited to the initial $1.50 paid and will be lost if TLT is above $123 at expiration. The max reward is the distance between strikes minus the initial debit, or $1.50, and will be captured if TLT sits below $121 at expiration.

To minimize the loss, you could exit the spread if TLT breaks above Friday’s high of $123.45.

As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.

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