Profit From the Bond Rebound

by Tyler Craig | January 4, 2013 12:30 pm

The buying bonanza in the stock market of late has come at the expense of U.S. bond prices. While the S&P 500 Index has been surging higher — along with markets across the globe[1] — amid optimism over the fiscal cliff deal, the iShares Barclays 20+ Year Treasury Bond Fund (NYSE:TLT[2]) has cascaded lower, on high volume to boot.

This week’s simultaneous rise in stocks and fall in bonds illustrates once again the strong inverse correlation between these two assets. In times of turmoil, the safety of U.S. Treasury bonds beckons the beleaguered investor searching for safety. Once the storm has passed and clear skies return, these investors often bid adieu to the safe harbor of bonds and begin searching for higher returns elsewhere — like stocks.

What’s interesting about the current downdraft in TLT — which has fallen 4.8% on the week — is that it’s getting a bit excessive and might be due for an oversold bounce.

One indicator that technical analysts like to use to help identify extremes in price is the Bollinger Bands. The chart study consists of an upper and lower band plotted two standard deviations around a simple 20-day moving average. Armchair statisticians should recall that two standard deviations represent about 95% of a data set. When applied to a price chart, this means the majority of candlesticks should be contained within the bands. Venturing outside the bands, then, should be a somewhat rare occurrence that signals the stock is at an extreme and likely due for a move in the opposite direction.

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As you can see in the accompanying chart, the price of TLT has indeed pierced the lower band, lending credibility to the view that a bounce is perhaps imminent.

Aside from Bollinger Bands, we also can look to volume for clues that TLT might be due for a rebound. Prior selloffs in the long-bond ETF have terminated on high volume. Four such instances are highlighted in the accompanying chart. As you’ll note, Thursday’s down move also occurred on much-higher-than-average volume. Time will tell whether this volume spike proves as prescient as the last four.

To exploit a revival in TLT, traders could sell the February 114-109 put spread for 75 cents or better. To initiate the position, sell the Feb 114 put while buying the Feb 109 put. The max profit of 75 cents will be captured provided TLT remains above $114. The max risk is limited to $4.25, but can be largely reduced by exiting the position if TLT drops below the short strike price of $114.

In timing the entry, consider waiting until TLT forms some type of bullish reversal candle. At the time of this writing, TLT had yet to develop any definitive signs of bottoming.

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

  1. markets across the globe:
  2. TLT:

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