A Low-Risk Entry Beckons in Bonds

by Tyler Craig | July 18, 2013 1:44 pm

Bond bulls find themselves in a pressure-cooker of sorts. Between the rapid rise in interest rates and continued advance of equities and other risky assets, bond prices haven’t been able to catch much of a break in the past two months.

The market gods flipped a switch in May, causing a pivotal turnabout in the behavior of Treasury bonds from semi-stable to out-and-out bearish, and they’ve entered a veritable freefall that has yet to abate. Since its July 2012 peak, the iShares 20+ Year Treasury Bond ETF (TLT[1]) is down roughly 18%.

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As a result of the sustained distribution in TLT over the past year, it has completed an ominous looking variation of a head-and-shoulders top on its weekly chart. In light of this now massive overhead supply, the name of the game in bond land will likely continue to be selling rallies.

And wouldn’t you know it — we’ve got just such a rally on our hands that looks ripe for fading.

This week’s rebound in TLT appears to be finding resistance in the area of its declining 20-day moving average. What’s more, it has reached the upper end of the downward channel that has defined its price action for the past two months.

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With TLT resting so close to resistance, a low-risk entry point has presented itself to those looking to exploit a continuation of the slide in bonds.

Although we’ve focused the entirety of our analysis on TLT, it is not the only vehicle available for trading long-term Treasuries. One of the common complaints with playing TLT is its somewhat anemic volatility.

Now, to be fair, the usually low-volatility bond fund certainly has had some excitement injected into its movement over the past month, and its realized volatility is actually near two-year highs (not shown). Yet, some traders still might be seeking a bond ETF with a bit more pep in its step.

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For that, we can turn to the Proshares Ultrashort 20+ Year Treasury ETF (TBT[2]). It’s essentially the inverse of TLT, but also provides 2x the movement due to its leverage. Plus, its price range is a bit lower ($74 vs. $108), so it opens up the possibility for other types of option positions like naked puts.

So here’s the play for you bond bears — sell the TBT Aug 70 put for 65 cents or better. Consider this a bet that TBT will remain above $70 by August expiration (which it will if bond prices continue to fall).

The max reward is limited to the initial 65 cents received. To limit the risk, you could buy back the put if TBT falls beneath the strike price at $70. Based on a risk graph, your estimated loss would be about $150.

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

  1. TLT: http://markets.financialcontent.com/investplace/quote?Symbol=TLT
  2. TBT: http://markets.financialcontent.com/investplace/quote?Symbol=TBT

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