Profiting From the Return of Risk Aversion

by Tyler Craig | November 8, 2012 8:27 am

The knee-jerk reaction to Wednesday’s long-anticipated election was one of negativity, to say the least. Any and all assets associated with risk were jettisoned from portfolios as money poured into the usual suspects of safety — U.S. Treasuries and the U.S. dollar.

Click to Enlarge
A brief survey of the PowerShares DB US Dollar Index Bullish Fund (NYSE:UUP[1]) reveals Wednesday’s pop in the greenback wasn’t all that significant. It already experienced a breakout from its recent two-month bottoming formation and has been in the process of rising for the past few trading sessions. Consider Wednesday a mere continuation of the breakout move.

Click to Enlarge
Treasuries, on the other hand, did experience a noteworthy move. The high-volume surge in the ISHARES Barclays 20+ Year Treasury Fund (NYSE:TLT[2]) breached the pivotal 50-day moving average as well as the upper trendline of a multi-month symmetrical triangle. If yesterday’s rally was indeed the resolution of the narrowing range that bond-watchers have been waiting for, a new up-leg in TLT may be in the cards.

Of course, your outlook on bonds should be influenced in part on which direction you think stocks will travel. If you’re of the opinion that yesterday’s downdraft in stocks will continue in the coming weeks, then bonds should keep rising.

For those looking to acquire additional bullish exposure to TLT, one play worth considering is initiating a bull put spread. This particular vertical spread consists of selling an out-of-the-money put option while simultaneously buying a further out-of-the-money put option. The position is entered for a net credit, which represents the max reward. The maximum risk is limited to the distance between strike prices minus the net credit.

Traders could sell the Dec 119-114 put spread for 70 cents or better. Provided TLT remains north of $119 by December expiration, the put spread will expire worthless, allowing you to capture the entire 70-cent profit. The risk is capped at $4.30 ($5 – 70 cents) and will be incurred if TLT falls beneath $114 by December expiration.

In the event the current breakout in TLT morphs into a fakeout, consider closing the spread if TLT falls beneath support at $120. Your estimated loss per spread at that point would be around 80 cents.

As of this writing Tyler Craig had no positions in any securities mentioned here.

  1. UUP:
  2. TLT:

Source URL:
Short URL: