by John Jagerson | October 23, 2013 9:07 am
The yield on 10-year Treasury bonds has been forming a long-term reversal signal known as a head and shoulders pattern. This pattern is an important one in the financial markets and is reliable enough that even the New York Federal Reserve has noted its predictive nature. However, the yield on the 10-year Treasury bond is impossible for most individual investors to trade.
There are ways to trade yields in the futures markets, but it’s unlikely that most individuals have a futures account. There are index options available on the 10-Year T-Note Interest Rate Index (TNX) that tracks the 10-year yield, but those aren’t very liquid so the trading costs make them an impractical alternative.
However, there are other ways to take advantage of the decline in yields without having to make compromises.
The head and shoulders pattern consists of at least three peaks in the price with the middle being the tallest. A line drawn between the bottoms on either side of the middle peak or “head” is called the “neckline” and should be flat or slightly uptrending. As you can see in the next chart, TNX has formed a head and shoulders pattern with a recent break below the neckline.
The price target for a head and shoulders pattern is based on the difference between the neckline and the head. That distance is then projected below the neckline to create a downside target. As you can see in the chart, the short term price target for TNX is based on the $4 difference between the neckline at $26 and the top of the head at $30.
Treasury bond prices have an inverse relationship to yields. If yields are falling, then Treasury bond prices are rising. This relationship never breaks because unlike other bonds, a Treasury bond’s price is a function of its yield. That means that Treasury bond funds should rise proportionately with a decline in yields.
As you can see in the next chart, bond yields and the iShares 7-10 Year Treasury Bond ETF (IEF) are perfectly inverse to each other. The trick with bonds like this is that they tend to rise in value faster than they fall, so timing in this trade is important. For example, the March-April decline in yields was over and done in a little more than a month.
There are three ways to take advantage of this kind of bullish opportunity in Treasury bonds.
1. The most direct route is a long position on IEF with a price target of $106 per share. We expect IEF to run into some resistance at that level when it reaches former support. This is a smaller percentage gain than the expected loss on TNX, but that is normal for the relationship between bonds and yields.
2. Alternatively, option traders may be interested in calls rather than an outright long position. Normally, this would be a great way to add some leverage to the trade. However, the options available on bond funds (including IEF) are usually fairly illiquid and therefore they have a wide bid-ask spread.
There is a solution that some option-traders may want to consider in either the iShares Barclays Aggregate Bond Fund (AGG) or the iShares 20-Year Treasury ETF (TLT). Both of those ETFs have much better liquidity in their option chain-sheet but it is more indirect exposure to the actual trading signal on the 10-year bond yield index.
3. Finally, very ambitious traders may even consider long positions on stocks that would benefit from falling yields. For example there are some popular mortgage REITs like Annaly Capital Management (NLY) and American Capital Agency Corp.(AGNC) that should rise considerably if yields fall. These have an even more indirect relationship with the original trading signal but the correlation is strong enough that it is an acceptable alternative for investors looking for an attractive opportunity.
InvestorPlace advisors John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.
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