Bond Bear Antes Up

A Choice of Instruments

Thanks to ever-expanding offerings, investors have a multitude of bond-related trading vehicles. The Chicago Board of Options Exchange offers options on four different interest rate indices, ranging from one with a 13-week duration to one that tracks rates on 30-year bonds.

But the main drawback with these products is that you cannot trade the underlying indices. This leads to a severe lack of liquidity in the options markets, because no spillover volume in the form of hedging or combination positions can be generated.

For example, the May options of the CBOE 10-Year Treasury Note Index (TNX) had open interest of fewer than 3,000 contracts as of Tuesday's close. If you do choose to wade into these markets, keep in mind that they are focused on yield, not price; if you think yields are going to rise, you should buy calls.

The tool of choice among traders seems to be exchange-traded funds, or ETFs, such as the various iShares that track Treasury bond portfolios. The most popular Treasury ETF is the iShares Lehman 20+ Year Treasury Bond Fund(TLT Quote). Currently the open interest in the TLT's two front-month options, May and June, exceeds 50,000 contracts -- far more than any of the other bond equity-based instruments.

Bond futures and their related options are still the dominant trading vehicle. They probably provide the most accurate, liquid markets for trading Treasury instruments across all duration periods. But they do have certain aspects, such as the need for a commodities futures account and pricing structures, that can make them inaccessible and inappropriate for many retail investors. The fact is, less then 15% of active retail equity traders maintain or trade in a commodity account.

So let's explore some possible bearish strategies using the TLT options. Even though the TLT does a fairly good job of tracking the movement of the benchmark 10-year Treasury note, it's not an exact proxy. For example, the average effective duration of the holdings in the TLT fund is about 13 years. This is reason to emphasize that the following suggestions are short-term trading positions, not longer-term hedging strategies, and should therefore be viewed as independent of any existing portfolio.

Also, remember, unlike the CBOE's index options, the TLT is based on price, not yield. If you think bond prices are going to fall (meaning yields will rise), you would buy puts or sell calls. Expect the TLT to move one point for approximately each 11-basis-point change in the 10-year's yield. At midday Wednesday with the TLT trading at $92, the 10-year Treasury note was yielding 4.22%, its lowest level in over two months.