Recently, traders have become increasingly stressed that bond yields will continue to rise and potentially get a little out of control. Comments this week from the European Central Bank’s Mario Draghi didn’t do very much to calm these fears, which means that a sudden spike lower is a higher probability than it has been recently.
However, just because the ECB says it won’t intervene to increase stability in the bond market doesn’t mean we think a spike is inevitable. In the past, the ECB has been perfectly willing to do the exact opposite of what it just said it would or wouldn’t do. This presents a situation where a sudden move lower in yields has increased in probability as well.
What we have concluded is that predicting the direction of bond yields is probably not going to be very productive in the short term. However, all this uncertainty about an intervention has made forecasting higher levels of volatility a much more reasonable estimate. This is the kind of situation where an option strangle might pay off in a big way.
Although a lot of the yield volatility in the bond market has been focused on European sovereign bonds, prices in U.S. Treasury bonds should be nearly as sensitive to global interest rate spikes, if not more so due to extreme uncertainty around the Federal Reserve’s future plans to raise interest rates.
Since yield volatility has been concentrated around longer-term bonds, we think the options on the iShares 20+ Year Treasury Bond ETF (TLT) are ideal for this strategy.
As you can see in the chart below TLT broke lower this week after hitting resistance near $123 per share. The large moves to the downside this week are inverse of the spike in long-term yields. The exchange-traded fund broke another layer of resistance at $119 on June 3, only to pause and retrace a little to “test” that level on June 4. Traders are no doubt watching this pivot level very closely for a signal that volatility is going to pick up again.
An option trader can use a straddle in a situation like this and buy a long call and put at the same strike price and expiration. The assumption is that if the price moves enough, the winning “side” of the trade will offset the loser, and the trader will walk away with a net profit.
An advantage of a straddle is that the maximum loss (of the entire premium) is only possible if the stock closes exactly on the strike price at expiration, which is incredibly unlikely. However, the disadvantage is that a straddle is a high-cost neutral strategy.
Alternatively, we like an out-of-the-money strangle in a situation like this, which is different from a straddle because the long call and put are both out of the money by about the same amount, and it costs a lot less. This increases the potential risk of a maximum loss. However, it also means that if our forecast for volatility is correct, the upside is much larger as a percentage of the investment.
Part of the reason for this is that an out-of-the-money option’s gamma is a much larger percentage of its delta. If that sounds Greek to you, that’s because it is Greek. The Greeks are variables that option traders use to evaluate an option’s potential price given certain outcomes.
Delta is an estimate of how much the option will move in price for a $1 move in the stock. As the stock moves, delta increases, and that increase is measured by gamma. Out-of-the-money options have a lower delta, and gamma is a larger percentage compared to an at-the-money or in-the-money option.
Since we are relatively neutral in our directional estimate for the underlying price, we think using a long call and put that are equidistant from the current at-the-money strike price is the best way to go. As of this writing, TLT is trading at $118.50 per share, and we like the July standard 117 puts and 120 calls for the strangle.
The breakeven points can be calculated (assuming the position is held to expiration) as the total premium paid plus and minus the strike prices. Currently, the total premium for this trade is $3.80, which means the break even points are $122.30 and $114.70, which have also been plotted in the chart. The right edge of the chart is equal to July’s expiration to provide a little visual-perspective for the amount of time the stock has to complete the expected move.
iShares 20-year+ Treasury Bond ETF (TLT): Chart courtesy of eSignal
Our case is essentially that the ECB and the Fed have created a situation where illiquidity, fear and a nearly mathematical certainty that long-term bonds will be unprofitable by maturity, has increased the potential for short-term volatility to an extreme level.
Clearly, there are risks to a trade like this, strangles and straddles are usually unprofitable, but because the risk profile offers unlimited gains against a limited loss, large winners can offset smaller losers. We think this is an interesting opportunity to dial up the risk a little with out-of-the-money options that should provide a much larger return on investment (ROI), if the ETF breaks out like we expect by expiration.
InvestorPlace advisers John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, 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 SlingShot Trader trade and get 1 free month today by clicking here.
You can learn more about identifying price patterns — like a bearish head and shoulders top — and using them to project how far you think a stock is going to move in their Advanced Technical Analysis Program.
