Bond Bear Antes Up

Playing chicken with the Fed is unwise. Options can help you profit from higher yields.
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This article originally ran on July 27, 2005, and is being re-run in anticipation of the Fed meeting on Tuesday.

After one of their most volatile two-week periods in the last eight months, bond prices the last three tradings days have settled down like an overtired baby. The tension that's building over interest rates suggests that this consolidation period can't last forever.

As I mentioned in passing on Monday, I think the

bond market looks vulnerable at current levels

and the better risk-reward trade is to be positioned for a rise in yields. The yield on the 10-year has tumbled some 30 basis points in the last three weeks on a couple of weaker data points. It has also been goosed by a flight to safety as stock prices suffered steep declines over the last two weeks. But stabilizing stock prices have removed some weaker hands of demand for Treasuries.

Duck, Duck, Chicken

Now we can focus on the economic data points, and more important, what

Federal Reserve

policymakers will do and say at the next FOMC meeting on May 3. A hotter-than-expected consumer price index vitiated the benign producer price index, and a stronger-than-expected housing market, which we know Greenspan is targeting for a takedown, pretty much offsets the weaker-than-hoped-for consumer confidence number. Wednesday morning's weak durable-goods number has caused some more knee-jerk buying of bonds and provides a very good entry point for establishing a bearish position.

With rates on the 10-year sticking stubbornly near where they were about two years ago, despite seven rate hikes in the last 10 months, it seems many investors are playing a dangerous game of chicken with the Fed. They are bound to lose. All indications are that the Fed will raise rates by another 25 basis points and maintain its measured stance and voice its continued concerns about inflation. With bond yields sitting near the low end of their two-month range, bond prices now seem much more susceptible to reacting bearishly to any strong or inflationary data or hawkish words from the Fed.

I'm currently looking for ways to get bearish or bet that yields on the 10-year will move quickly back above their March high of 4.62% within the next three weeks.

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) - Get Report

. 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.

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.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to

steve.smith@thestreet.com.