Little Reward, Increasing Risk: Short Treasury Bonds with Options

If long US Treasury Bonds are overpriced, here is a low cost hedge suggestion against rising long-term interest rates with defined and limited risk.

iShares Barclays 20+ Year Treasury Bond (TLT) 112.73. This ETF seeks to duplicate results corresponding to the price and yield performance of the long-term sector of the United States Treasury market as defined by the Barclays 20+ Year U.S. Treasury index.

After reaching a 123.15 high on December 18, 2008 TLT has declined below the upward sloping trendline defined by the November 13, 2008 low at 93.25, the December 12, 2008 low at 110.34 and the December 31, low at 118.85. The quick three-point decline on January 2, 2009 was most likely caused by the Barron’s sell signal published in the January 5^th edition. Then last Friday, Bill Gross at PIMCO wrote that the current Treasury securities low yield “offer little reward and increasing risk.”

For those who think the funding requirements of the US Government will eventually cause interest rates to rise as more issues are brought to market thereby materially increasing the supply then TLT, with good options volume and open interest, offers an opportunity to create short positions in the Treasury security market with defined and limited risk.

The current Historical Volatility is 30 and the Implied Volatility Index Mean is 25.47.

Consider this bear put spread suggestion.

• Buy TLT Mar 110 put ILTOB 4.95 IV 30.52 Delta -.4173
• Sell TLT Mar 105 put ILTOA 3.05 IV 31.19 Delta .2923

Debit 1.90 Position net delta -.1250

The debit indicated above is based upon Friday’s middle closing prices between the bid and ask. Considering time decay, the debit today should be about 1.89 if the stock price remains unchanged. Use the position net delta shown above to adjust for any stock price change or about .29 for each point change in the stock price.

Use a close above 120 as the SU (stop/unwind). The current TLT pattern has the look of a developing Elliott 4^th wave which as the potential for a higher high than the December 18, 2008 high at 123.15. This could correspond with a final 5^th down wave in the equity market equating to long treasury rates in the low 2% range. While this seems unlikely with a recovering equity market, it could be possible if equities continue lower. Recent experience has given us more respect for unlikely market developments. In the event TLT reverses and rises back above 120 close this position and wait for the next opportunity that will come in the near future as long-term interest rates start to rise.

The maximum risk is defined and limited by the amount of the initial debit, in this case $190 for a one-lot position. For the defined and limited risk we accept that this position also has a limited upside potential defined by the difference between the strike prices less the initial debit or cost. The difference between the strike prices is five points, less the debit of 1.90 gives a maximum gain of 3.10 for a risk reward ratio of 1.63. By paying careful attention to the SU (stop/unwind) the risk can be further reduced in the event it moves the wrong way as we explain above.

Disclosure: no positions