Play the Bond Teeter-Totter

by Tyler Craig | September 27, 2012 9:12 am

In the heart of Wall Street lies a playground with a giant teeter-totter whose movements are driven by investors’ appetite for risk. While stocks sit on one end of the teeter-totter, bonds sit on the other. Given their opposing locations, the two assets exhibit a strong negative correlation. The rise in one typically results in the fall of the other. This relationship has played out in spades over the past two weeks.

While stocks have been grappling with a bearish reversal of fortune following Fed Chairman Ben Bernanke’s recent QE3 announcement, bonds have rallied quite nicely. In fact, the iShares Barclays 20+ Year Treasury Bond ETF (NYSE:TLT[1]) is up eight days in a row.

Click to Enlarge
However, with the declining 50-day moving average and a descending trend-line looming overhead, the upturn in bonds may have run its course. Furthermore, the risk-reward certainly seems to favor bearish plays at this stage for those willing to bet the teeter-totter tilts back in favor of stocks over the coming days.

One high-probability strategy worth considering is the bear call spread. Traders could sell the Nov 130 call while buying the Nov 135 call for a net credit of 70 cents or better. The max reward is limited to the initial $70 received and will be captured if TLT remains below $130 by November expiration. The maximum risk is limited to the distance between strike prices minus the net credit, or $430.

Of course, to reduce the risk in the position, traders could exit early. A popular technique with credit spreads is to close the position if the stock reaches the short strike price — $130 in this case. If exited in this manner, the loss would probably come out to around $100.

At the time of this writing Tyler Craig had no positions in TLT.

  1. TLT:

Source URL:
Short URL: