Bond Options Might Do the Job

With each passing month of disappointing payroll data, the subsequent month's report seems to take on greater significance. The anticipation for this Friday's report is now approaching End of Days proportions. While this latest chapter in the Labor Department's never-ending tale won't save our souls or offer eternal salvation, it might provide a means for more earthly gains.

The prevailing belief is that the only thing preventing the Federal Reserve from raising overnight lending rates above 1% is a lack of job growth. The latest prophecies are for the March report to show an increase of 130,000 new nonfarm payrolls. Some preachers of "the recovery is now, and the world of low rates will end on Friday" gospel are predicting growth of as many as 250,000 jobs. It is this hope (or fear) of a big number that has many traders looking to position themselves for a selloff in bonds.

However, other factors are at work that make being short bonds the trade of choice as well, including the lack of value at current yield levels, recent rumblings from Fed members that a move is imminent, signs of inflation, expectations for strong first-quarter earnings, and the possibility that Japan may be backing away from its currency intervention policy. (These issues were discussed in Tony Crescenzi's article earlier this week.)

Bonds, Futures and Options, Oh My!

Thanks to ever-expanding offerings, investors have a multitude of bond-related trading vehicles. But while bond futures and related options probably provide the most accurate, liquid markets for trading Treasury instruments across all duration periods, they 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. (I mentioned many of these issues in a past article.)

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 April options of the CBOE 10-Year Treasury Note Index (TNX) had open interest of fewer than 1,000 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 Lehman 20+ Treasury Fund ( TLT). TLT's April options currently have more than 40,000 contracts open -- far more than any of the other ETFs. So let's use it to explore some possible bearish option strategies.

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 current duration of the TLT portfolio is about 23 years (for the details on TLT's contract specifications, click here), and this is reason to note that the following suggestions are short-term trading positions, not longer-term hedging strategies and should therefore be viewed independent of any existing portfolio.

Bearish, More Bearish and Bearishest

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. On Tuesday, the TLT closed at $89.10, and the 10-year Treasury note was yielding 3.90%.

The implied volatility of the TLT's at-the-money April options has been creeping up of late, rising to 12.5% from 10% over the last week, mainly because of the recent bond selloff and in anticipation of the jobs report. This higher implied volatility, and the fact that we're heading into the sweet spot of the time decay curve with just over three weeks remaining in the April series, means I'd first look for a move that employs a selling premium or is done for a net credit.

You can currently sell the April $88 call for about $1.50. But there are two main problems with this.

First, profits are limited to the sale price of the call. Second, the losses are unlimited should bond prices stage a strong rally on a weak jobs number, which, given the recent string of disappointing data, is very real possibility. We can solve the second problem and cap our losses by turning the position into a bearish call spread. This could be accomplished by buying an April call with a $90 strike price for 40 cents a contract.

The short 88/90 call spread's maximum profit of $1.10, or $110 a contract (the net credit), is realized if the TLT falls below $88, and a maximum loss of $90 a contract is incurred if the TLT rises above $90. The break-even point is $89.10, or essentially Tuesday's closing price.

This is still not a great profit profile, especially for those looking for a big jobs number and a correspondingly big decline in bond prices. So we need to turn our attention to buying puts. You can currently buy the April $88 put for about 50 cents, or $50 a contract. This has a limited loss of $50 per contract for any price above $88, a break-even point of $87.50, and an unlimited profit potential as prices decline.

If you really want to get aggressively short but not pay out a lot of premium, I'd suggest looking at combining the above two positions.

Use the premium collected from the short-call spread to finance the purchase of an April $88 put. Of course, this is very similar to simply shorting 100 shares of TLT and buying one $88 call for upside protection. The main difference is that the break-even point for the short shares/long call position is $87.50, as opposed to $88.50 for the all-option position.

In the former position you'd need the TLT's price to decline $1.50, or 1.6%, before becoming profitable; the latter position only needs a 50-cent move before a profit is realized. This is a difference between a 10-year yield of about 3.96%, and a yield of 4.09%.

The table below shows how the positions would fare at various price levels. (The TLT at $86 roughly equates to a 10-year yield of 4.26%.)

Bearing Down on TLT Options
Profit and Loss at Various Price Levels
Position Credit/Debit Break-Even Point $86 $88 $90
Short 88/90 Call Spread $1.10 $89.10 $1.10 $1.10 $(0.90)
Long 88 Put (0.50) 87.50 1.50 (0.50) (0.50)
Combination 0.60 88.60 2.60 0.60 (1.40)
Source: TSC Research

For some people, simply buying a put might make the most sense. For others, it might be just shorting the call spread or using various combinations, ratios and strike prices that may look more attractive. Remember, there is no right way. Pick the position that best aligns with your comfort level and market expectations.

Steven Smith writes regularly for 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

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