With the global economy currently facing a troika of threats - the European sovereign debt crisis, the slowdown of the U.S economy, and China hard landing - investors have sought the safety of U.S. Treasuries and pushed yield at record low levels. The yield on 10-year bond is hovering around 2% (TNX), while the yield on 30-year bond is around 3% (TYX).
In our opinion, yields on Treasuries will remain range bound at these levels until June of 2012 because supply from the Treasury Department and demand from the Federal Reserve (the Operation Twist) are offsetting one another. Given the presumed stability of the Treasury market, we believe that selling options on the underlying asset (TLT) will be a rewarding strategy and we offer three actionable strategies.
Strategy 1: Covered Put
For those with long-term bearish views on the US debt, sell short TLT and sell an at-the-money weekly put. Let us illustrate the strategy by way of example. At the time of writing, TLT shares trade at $116.50 and investors can collect up to $1.63 per contract by selling a weekly put with strike price $116 that expires on November 11, 2011. This strategy is equivalent to selling a naked call and investors should be aware of the risks involved.
The $1.63 is for investors to keep no matter what happens at expiration date next Friday. If TLT closes at less than $116 next Friday, the total pay-off for the trade is $2.13 or slightly less than 2% for one week. On the other hand, investors need to have enough cash on hand if TLT shares move higher (not to receive margin calls). They also need some tolerance for market fluctuations as TLT shares can move sharply. For example, when Greek Prime Minister Papandreu announced the referendum, TLT shares snapped from $113 and change to $119.45.
Note that investors are responsible to pay dividends on TLT. This amount however is small compared to the amoung collected from selling weekly puts. For example, the dividend is equal to 30 cents for the month of October, while investors would receive a much higher amount from selling puts weekly (presumably more than $3 per contract).
Strategy 2: Covered Call
For those with short-term bullish views on the US debt, long TLT shares and sell an at-the-money weekly call. An advantage of this strategy is that investors receive the dividends. Investors can collect up to $1.50 per contract by selling a weekly call with strike price $117 that expires on November 11, 2011. This strategy is equivalent to selling a naked put.
Strategy 3: Calendar Put Spread
For those with long-term bearish views on the US debt but who do not have the conviction to sell short TLT shares, a calendar put spread can be the way to go and is implemented as follows. Go long a long dated put (e.g. with expiration June 2012) and sell short-term weekly puts. For example, investors can buy the $115 put that expires in June 2012 for $8.90 and sell the $115 put that expires in one week with strike price $115 for $1.20.
The three strategies work best if the value of TLT shares remain stable around $115 until June 2012.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: I have bearish put spreads on TLT