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Interest Rate Limbo Dance

|Includes:iShares 20+ Year Treasury Bond ETF (TLT)

We all probably knew investing would be like a game of chess or dancing but limbo dancing? That’s the exact thesis running around the investment world right now for US Treasuries of “how low” can interest rates go. Should you go running into the TBT, that doesn’t jive with me due to well decay factors to it being a “leveraged” ETF vehicle. Now I have traded TBT and still will its just the current economic path and market scenario in my brain doesn’t jive with a “rates are going to stop here” and I can use a short-term trading vehicle. So my vehicle of choice is the TLT. Its bullish on treasury prices or goes up in value when rates go down. That’s the opposite of my long-term view of treasury rates but I am racked by analysis paralysis of trying to pin down the exact time frame to justify playing it via calendar put spreads.

The reasoning behind that is two fold; which isnt really the point of this blog and wont be addressed in detail. If you are curious about the reasons please leave a comment and I will write a separate article addressing it.Getting on with the point, I decided to get bearish this week at two levels (just the first of possibly many entries) via my favorite instrument OTM Bear Call (Credit Call) spreads. The low-mid $105’s and mid $106’s on TLT. Why both? Well I liked establishing the position in the low-mid $105’s on 8/18/10 as the call premium was attractive and I really liked it today 8/20/10 when TLT was $106.50’s (3rd spike into the level that made a lower high than the 2nd spike). I decided to attack via OTM Bear Call spreads to give myself room for error as well as I didn’t want to put a ton of value at risk this soon in case of fat tail risk such as Isreal attacking Iran, some bad government policy or who knows.

After all, Intel did possibly the stupidiest acquisition of the year (I was bullish on INTC but am mildly bullish in my deltas but hedged). The first trade in the low-mid $105’s on 8/18 was September $109-$111 bear call spreads that I established for $0.74 (on average) and $0.45 (on average), respectively. This gave me a net credit of $0.29 against a $1.71 maximum value at risk per spread. This equated out to return of 16.95% against the maximum value at risk. The risk reward doesn’t really seem good but given the short-time frame and the theta decay and being 3.83% OTM (not a lot but its long-term treasuries) seemed to mitigate some of the risk reward factors.Also given my view of treasury rates, after all they cant go negative and how much would investors really accept on a 20-year holding period (as I doubt those people are looking at trying to book substantial capital gains) I kept the trade size small so I can “short” more at higher and higher levels on TLT. Not always “doubling” down but adding positions along the path as I am pretty confident that rates will go back up. So essentially in these first set up trades I am trying to “time” it somewhat but also trying to eliminate “path” risk. Usually one is right about a stock, commodity, interest rate in the end but the real key to investing is making sure your position can “survive the path” it takes to reach the profitable ending.

So with that being said, by keeping these very small at first, I can essentially short at higher and higher levels of TLT till essentially interest rates go negative. Eventually if prices continued to move up on TLT (aka interest rates going down) I would begin to switch from shorting theta to being long theta via put spreads, calendar put spreads and owning outright put options.The next trade in TLT occurred today with TLT reaching into the $106.50’s again and then beginning to drop down. I felt the time was right to add (even though in dollar terms it wasn’t far away from the $105’s) but I liked the premiums in the $109’s. I shorted at a 1:1 ratio to the original $109-$111 OTM bear call spreads $109-$110 OTM bear call spreads. I ended up getting $0.20 for the $109-$110 OTM bear call spread package. So I have $0.80 maximum value at risk per spread + $1.71 maximum value at risk per spread equaling a total maximum value at risk of $2.51. Total returns if TLT is below $109 would be $0.20 + $0.29 or $0.49. Maximum profits would be 19.52% against the maximum value at risk.

I decided to start a similar master thesis trade like my UNG/NG trading as I felt the time was right to start a baby sized trade to reflect my view. Get a “long-term” price move/ range/point in your head and figure out how best to reach that long-term price move/range/point without putting it as your entire portfolio because you got to aggressive in the beginning.The thesis is that eventually rates will go back up as they cant go negative and on long-term instruments one had to think what investors will settle for. Some interest subscriptions I have stated that 2.50% on the ten-year was a big level for a variety of reasons and that correlates to roughly $107 I believe. So it puts me a decent amount above that. If the trade proves to be well timed and rates start to go back up and TLT goes down I may move down the short $109 strikes to $108’s and $107’s to collect more premium (at the expense of more value at risk) but I would be quick to capture profits via setting mental stops or programmed trades to automatically exit me out.

But I may also go into calendar put spreads or put spreads if I think the move will be sustained.I am not bullish on the economy, more of a lost decade type of guy right now. However the bond market is saying one thing, the stock market is saying another and commodities are saying another. So an investor has to take a stand somewhere or else sit in cash. I am already sitting on a ton of cash in terms as a percentage of my portfolio so I felt like this was a good opportunity to put a tiny bit of cash to work (well in terms of margin requirement usage as I collected cash on the trade). I will post any updates as I have them after trading hours are complete as I likely wont have access or time to write during the trading day.

In summary, I am cognicent that rates can continue to go lower but wanted to get some bearish exposure on treasury prices (betting that rates go up) but am doing it in a very risk defined method but is offering limited returns as well with not the greatest risk reward set ups. Also I do plan on adding additional bearish positions along the way, but at what levels is to be determined based on market prices, fears, perception and general malaise that may occur and negatively affect the position I am in.

Disclosure: Bearish on TLT as posted above, mildly bullish deltas on INTC

Disclosure: Disclosure: Bearish on TLT as posted above, mildly bullish deltas on INTC

Stocks: TLT