Banks in the United States are preparing for another round of stress tests by dumping high-risk bonds. According to data from the Fed, banks reduced their positions in these bonds by 68% in October, which is the largest selling frenzy on record.
To capitalize on this, we’re opening a new bearish trade on iShares iBoxx $ High Yid Corp Bond (ETF) (HYG).
The price of junk-bond ETFs (like HYG) likely didn’t reflect the selling because of the bounce in equities over the last two weeks. However, high risk bonds look…well, “high risk” at this point and should be a very profitable bearish position whether stocks channel or decline in the short term. The announcement by the Fed on today could easily be a catalyst for a breakout and, with HYG hovering at resistance (on a dividend-adjusted basis), we like positioning for a drop now before prices begin to accelerate.
Buy to open the HYG December 92 Puts (HYG141220P00092000) for a maximum price of $1.80.
In this high-risk environment, we’ve been asked if we would recommend stop losses on options trades. Stops are tough in the options market, and we almost never recommend them because normal market volatility for an option (30%-60%) can lead to a lot of unintentional early exits.
Instead, we emphasize the importance of proper position sizing – that is keeping the allocation for each of your trades a small, consistent percentage amount of your trading portfolio, somewhere in the range of 3% to 5%. For many traders, this may mean just trading one or two contracts in each options position, and that’s fine to start with. That way, if a trade goes against you, you still have 97% to 95% of your money either left to trade with or working in other trades that are likely to succeed.
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