Bond Bear Antes Up

Bearish, More Bearish, Most Bearish

Two simple alternatives for establishing a bearish position are selling calls or buying put options. The risk-reward and other differences of short calls vs. long puts was explained in a recent article. If you are willing to get aggressively short but not pay out a lot of premium, I'd suggest looking at a combination of the above two positions and using the premium collected from the short call to finance the purchase of a put.

For example, on Wednesday with TLT trading at $92, one could sell the May $92 call at 80 cents and buy the $91 put for 55 cents, or a net credit transaction. Of course, this is essentially a synthetic short and is very similar to simply shorting 100 shares of TLT. The main difference is that the break-even point has been increased to a higher price. The short shares have a break-even point of $92, while the all-option position, or synthetic short, does not lose money unless the TLT climbs above $92.45 per share.

My Best Bet Is Back -- the Backspread, That Is...

But I'd like to focus on the ratio backspread strategy. It's a position that still enjoys a relatively low and limited risk, but offers unlimited profit potential from the movement in the underlying security's price and an increase in the implied volatility of its options. It's one of the most powerful options positions you can establish when anticipating a significant price move.

The ratio backspread consists of selling an at-the-money option while simultaneously buying out-of-the-money options on a ratio basis. The idea is to buy the greatest possible amount of out-of-the-money options for the price of the at-the-money options sold, creating a position with the highest long/short ratio for as little money as possible.

For example, on Wednesday you could sell the May $92 put at $1.10 per contract and buy the May $90 put at 25 cents, allowing for the creation of 1x4 backspread for a small net credit of a dime -- hey, it helps cover commissions. The attraction is that if bonds move higher, all of your options will be worthless and the position loses no money.

But if yields drop to the expected 4.60% level, which would translate into TLT's share price of roughly $88.55, the position would have a profit of $2.35 per 1x4 spread. The profits expand rapidly as the price of TLT declines. The only real danger and downside is if the TLT settles between the two strikes, with the maximum loss of $2.00 being realized if TLT settles at $90 when the May 20 expiration comes.

Choose your approach wisely and wait patiently for investors to eventually blink and steer in the direction the Fed is driving interest rates.