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Fixed Income Exposure

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So far, we have been staying out of the way of the selloff in fixed income that began early in May. I mentioned last week that the rally in rates was a reason to be optimistic about the economy, but for short-term traders it has been too difficult to pick a bottom. However, over the last several sessions, bond traders and currency speculators/carry traders have been unwinding positions with enough force that the odds of more weakness in bond prices are diminished.

Short term implied volatility in iShares Barclays 20+ Year Treasury Bond ETF (TLT) rose again on Monday, but longer dated option volatility actually fell on the day. Two and three month TLT option volatility, at about 15%, are just barely lower than a six month estimate. Backwardation in TLT options is a rare occurrence, usually only associated with major risk-off situations. Until the economic data suggests otherwise, we have no reason to look for a broad market correction, and we can expect implied volatility to decline from here.

I think it's still a good idea to avoid very short term trades, but the scenarios outlined by Mark Dow are plausible reads on what the fixed income risk/reward setup should be like in the near term:

"This leaves us with two basic scenarios. One, if the equity market rebounds, the 'fear discount' now built into a lot of [fixed income] instruments will come out and Treasuries should stabilize if not rally, given the speed, fear and volume behind the recent selling."

"Two, if, instead, the equity market sells off further from this point--which we got a taste of on Friday--then Treasuries will rally, as they tend to when risk aversion rises far enough or fast enough in equities. In fact, we got a taste of this on Friday as well. This scenario should trigger at a minimum a modest rally in the some of the FI instruments hit hardest by the bond selloff."

To trade the view we're working with, the following position has a profile similar to that of a risk reversal, but with limited downside risk. We're effectively selling a vertical put spread and using that credit to finance the cost of an out of the money call option.

Trade: Buy to open the TLT August 105 put for $0.57, sell to open the August 109 put at $1.19, and buy to open the August 123 call for $0.56.

In the short term, this position acts like simply being long TLT. As time passes, though, spot relation to the option strikes starts to matter more, and at expiration, we would keep the opening credit with TLT between 109 and 123; my intention is to hold the trade into July if needed, targeting a gain of $0.90 or so.

OptionsProfits can be followed on Twitter at twitter.com/OptionsProfits.

Jared can be followed on Twitter at twitter.com/CondorOptions.

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