In my recently published article titled "Shorting Treasuries With The TBF: A Historic Opportunity," I opined my view that the 80-year lows in U.S. Government Bonds were due to reverse course, as bond buyers will eventually come to their senses and stop lending money to the U.S. Government at a rate that is less than inflation. As with any investment hypothesis, the question is when, and this question dominated the comments section of the article.
In the previous article, I didn’t explicitly say when I expected this trade to pay off, or specify my actions around this position, which is the purpose of this article.
As many commentators on my last TBF article pointed out, the Fed has stated that it plans to keep rates low until at least 2013. That being said, the latest 20+ year bond rally appeared to ignite with what was known as “Operation Twist,” a program by the Fed to flatten the yield curve in the name of stimulating the economy. With the effects of this program largely realized, as well as the irrationality with lending rates to the US Government for 20 years at a sub 3% yield, this as an excellent entry point into TBF.
I share the view that in the next few months bond yields may stay at these low rates, but with little or no downside, this presents an excellent opportunity to generate income via writing covered calls. In the best case, TBF will be sold at a profit plus the premium from the call, at the worst TBF will stay flat and you’ll collect the premium for writing the call. Charted below, the purple line is at $33, just outside the trading range of the past few months, making it a logical spot to write calls.
(Click charts to expand)
Assuming you own 1000 shares of TBF worth $31,860, if you were to sell March 2012 calls with a strike of $33, you’d earn $900 based on the last trade price. This equates to a return of 2.82% in a little over 2 months, which if you could do six times over the year, equates to $5,400 or a 17% return. Of course, the stock could be assigned away before then, but if this were to occur and TBF were to begin a rally, you could buy back in to participate.
The one catch to this trade is that TBF, due to its esoteric nature, has relatively illiquid options. Looking at the charts below, you’ll see that there is little open interest in the February calls (white boxes) and thin open interest and volume in the March calls (red boxes). One of the reasons I cite the $33 strikes rather than other prices is that due to its open interest and call volume, this is an order that has a higher probability of getting filled.
This leads me to an enjoyable conversation I had today with regards to the markets and high frequency trading. A complaint that is often voiced by the political class and misguided investors is that high frequency trading adds no value to the market. They further suggest that the practice should be banned, discontinued and so on, and that subsequently markets would be better off.
TBF’s options are an example of why markets wouldn’t be. HFTs (high frequency traders) not only narrow the bid ask spread lowering costs to retail investors, they add liquidity enabling retail investors to take positions and have their orders filled in a timely fashion. Think of the markets as a giant ecosystem. There are the obvious species, such as the lions, tigers, chicks and foxes; but there are also the less obvious but equally important organisms such as the bacteria at the bottom of the food chain that ultimately enables the lions and tigers to eat. That bacteria is the HFTs.
Back to the trade, using a covered call strategy on TBF is an opportunity to earn an impressive yield while waiting for the Fed to discontinue distorting the markets. If you disagree, I have an order to sell calls at $0.75 yet to be filled that you may be interested in.