TLT Options: Taking Advantage of Interest Rates

Nov. 1.09 | About: iShares 20+ (TLT)

Risky assets have taken the front stage as investors clamor to increase the yields within their portfolios. Because of the flight away from quality, treasury securities have fallen slightly out of favor and 30 year yields have crept up to about 4.3%. There have been many comparisons between the current US economic environment and that of Japan in the 1990s and I want to explain where that comparison falls apart. Japan entered their malaise as a country of savers whereas the United States entered its crisis with a heavy burden of debt. That is a very important distinction that has swayed me towards a trade that I think has a very high probability of being right.

If we believe in any recovery in the world economy then I think it is safe to say that we will not see 30 year treasury yields hit 2.5% as they did on December 18, 2008. Those yield levels were crisis levels. That occurred when there was an extreme flight away from all risky asset classes and into safe assets such as treasury bonds and agency backed mortgage securities. At the time, it did not seem that shorting treasuries was a "no-brainer" because we all know that the crisis would unleash many more months of pain.

Treasury securities sky-rocketed when there was a flight to qualityClick to enlarge
Treasury securities sky-rocketed when there was a flight to quality

The rising prices in risky world assets is a signal that risk-appetite has returned and fear has subsided. Now is the time to assess what that means going forward. The harsh reality is that the United States has a massive amount of debt and is currently paying very low interest rates for that privilege. It is my opinion that will change, and it might even occur very rapidly if consumer demand picks up and inflation scares spike. Betting that interest rates will increase can be done very easily by shorting treasuries (TLT or Bond futures) or by buying put options on those same underlyings. I am not going to make that bet outright, instead I am going to take a more agnostic view and just make some bets on where interest rates should not go. It is helpful to look at where yields were and what that meant for the price of the instrument I want to use to facilitate this bet.

Long rates hit 2.5% at the low and now hover well above 4%Click to enlarge
Long rates hit 2.5% at the low and now hover well above 4%

Now that we have both the yield and price charts, we can make some statements regarding the relationship. At a yield of about 4% the TLT (20+ year treasury ETF) traded at about 100 and at 3.5% TLT traded at about 106. I believe that both of these levels provide good barriers to sell call options on TLT.

When I sell options I generally look at selling options that are 3-6 months out. I find that a longer option gives you more breathing room so that you do not get stopped out of the position. When selling very short options you get fantastic time decay (theta) but small changes in price can stop you out of a position more quickly. This would lead me to recommend looking at March or June 2010 contracts.

100 and 105 strikes trade for 2.25 and 1.20 respectivelyClick to enlarge
100 and 105 strikes trade for 2.25 and 1.20 respectively

If you sell these call options at the ask price, then you receive $2.25 for the $100 strike or $1.20 for the $105 strike. This will pay you $225 or $120 per option sold as long as rates do not go lower than 4% or 3.5% by June of 2010. I think this is a high probability trade. If you want to make this more aggressive then you can look at selling the calls and buying put options. That way the purchase of the puts would be partially paid for by the written calls.

I like this trade because it makes good economic sense and because it provides protection against a rising interest rate environment. Remember that rising interest rates are generally bad for equities and very bad for fixed income investments, so you can view this as a partial hedge against your other fixed income assets. The risk is that interest rates plummet as there is another flight to quality. In that case all assets besides treasuries are declining and we probably have more important things to worry about.

Disclosure: Short TLT