Bond Markets Often Lead Stocks
It was more than 25 years ago. Bill Clinton was running for President. Like most campaigns, it was difficult at times to focus everyone’s attention. Some advisers wanted to target foreign policy, others energy policy, and others had their pet policies competing for the attention of the candidates.
James Carville was among Clinton’s closest advisers. He came up with a way to simplify the campaigns. Everything the candidate did or said should support one of three key themes.
- Change vs more of the same.
- It’s the economy, stupid.
- Don’t forget about health care.
This proved to be a winning outline for the election. And, Carville looked to the market for guidance as to whether or not important economic announcements were on track or not. Carville respected the opinion of the bond market.
It was around that time that Carville famously commented: “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”
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According to some, “the bond market’s status has only grown since then, in the wake of the financial crisis. According to the BIS’ latest quarterly review, since 2010 bond markets have been the main conduit for credit expansion, rather than bank loans.”
That means we often see decisions related to bonds affect the price of stocks.
An Example of Bond Markets Leading Stocks
RH (NYSE: RH) operates as a retailer in the home furnishings sector. It offers products in various categories, including furniture, lighting, textiles, bath ware, décor, outdoor and garden, tableware, and child and teen furnishings.
The company was formerly known as Restoration Hardware Holdings, Inc. and changed its name to RH in January 2017. Recently the company needed financing and Business Wire reported,
“RH announced that it intends to explore a potential offering of $300 million aggregate principal amount of convertible notes due 2023 in a private offering to qualified institutional buyers.
In the event the Company chooses to complete the proposed $300 million offering, RH would expect to enter into convertible note hedge and warrant transactions that are designed to offset the effect of any dilution from the conversion of the notes up to approximately 100% over the common stock price at the time of pricing of the notes.
The financing would be opportunistic and as such the proceeds would be used to provide the Company with a flexible source of funding to pursue favorable long term allocations of capital. Proceeds of the offering would also be used to pay down the outstanding borrowings under the Company’s credit facility and to pay the net costs of the convertible note hedge and warrant transactions.
The interest rate, conversion price and other terms of any new issuance of notes are subject to the final pricing determination in connection with any offering. The notes would be convertible into cash, shares of RH’s common stock, or a combination thereof, at RH’s election.”
Traders in the stock market seemed pleased with the news.
The rally in the stock could indicate the recent pull back is over and the up trend that has defined the stock’s action for most of the past few years could be ready to resume.
Trading the Trend
When a stock is expected to move higher, traders could consider obtaining long exposure to the stock to profit. A number of options strategies could be used to meet this objective.
Among those strategies is a bull put spread. The risk and reward diagram is shown below and it offers limited risk with limited potential gains. However, it is well suited for a stock which is in an up trend.
Source: The Options Industry Council
This strategy involves two put options. One put option is bought and a second put option with the same expiration date but with a lower exercise price is sold. Selling the put option will generate immediate income, just like the more familiar covered call strategy would. But, unlike a covered call, risk is limited.
Many traders will be familiar with the idea of a covered call. This is a conservative strategy many long term investors use to generate income in stocks they own that are unlikely to make large moves.
Although the bull put spread is different than a covered call, the bull put spread strategy meets the same objective as the covered call which is to generate some income. This trade generates immediate income and carries limited risk.
A Specific Trade for RH
For RH, a bull put spread could be opened with the December 21 put options. This trade can be opened by selling the December 21 $135 put option for about $4.70 and buying the December 21 $145 put for about $9.60.
This trade would result in a credit of $4.90, or $490 per contract since each contract covers 100 shares. That amount is also the maximum potential gain of the trade.
The maximum possible risk is the difference between the exercise prices of the two options less the premium received. For this trade, the difference between exercise prices is $10 ($145 – $135). This is multiplied by 100 since each contract covers 100 shares.
Subtracting the premium from that difference means, in dollar terms, the total risk on the trade is then $510 ($1,000 – $490).
The potential gain is about 96% of the amount of capital risked. This trade will be for a short amount of time and the annualized rate of return provides a significant gain.
The bull put spread is an example of how options are a versatile tool and could meet many of your trading objectives. In this trade, options provide income and defined risk that could be lower than owning the stock. This strategy also has a high probability of success.
These are the type of strategies that are explained and used in TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your goals, click here for details on Options Insider.