This Could Be the Best Trade for Rising Rates
The 10-year U.S. Treasury yield rose to its highest level since 2011, extending a selloff in the world’s biggest bond market and raising fresh questions about how high America’s borrowing costs will climb. The dollar reached the strongest point since December.
The 10-year Treasury is a global borrowing benchmark and yields topped 3.0539% on Tuesday, the highest level since January 2, 2014. Analysts attributed the increase in rates to a report showing retail sales rose in April.
One analyst noted, “The rout in Treasuries comes amid a flood of new issuance and as the Federal Reserve is projected to boost interest rates further. Inflation expectations are hovering near the highest since 2014, after years of doubts about whether prices and wages would increase.”
The End of the Bond Bull Market
As rates rise, prices of bonds fall. The chart below shows that 10-year Treasury futures have been forming a topping pattern over the past two years.
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Bonds have been a bull market since 1981 when interest rates topped 15%. As rates fell, the prices of bonds rose. This is because buyers will demand a premium for older bonds that offer higher interest rates.
For example, if the bond paid a 15% interest rate, traders would be willing to pay more than its face value when rates fell below 5%. This made the old bonds worth more than new ones and led to the bull market that has now been in place for more than 35 years.
Now, it appears that interest rates are reversing course. The Federal Reserve has been raising short-term interest rates since December 2015. The market sets long-term rates and it now appears that market is following the Fed’s lead and pushing rates up.
Normally, economists expect the interest rate to provide compensation to investors for lending money and provide a cushion against inflation. Low inflation explains low interest rates, to a degree. But, Fed policies seem to have lowered the component of interest rates that compensates investors.
In a normal market environment, that compensation is generally between 1% and 3%. Using the midpoint of 2% and expected inflation of 2%, the interest rate on the 10-year Treasury should be about 4%. That’s well above the current level.
If rates continue to rise, bond prices will continue to fall. That creates a trading opportunity for investors.
Some traders will use futures to obtain exposure to interest rates. But, that market carries a high level of risk. There are strategies that can strictly limit the risk and they could be implemented for relatively small amounts of trading capital.
Options offer a tool for investors to benefit from a potential rise in interest rates. This means traders should consider buying a call option on an ETF that tracks interest rates. This is one of the simplest options strategies available. Buying a call option can deliver a gain if the price of the ETF moves higher.
The maximum amount of risk on the trade is determined when the position is opened. A trader can never lose more than the amount they pay to buy a call. The risks and rewards of this strategy are summarized in the diagram below.
Source: The Options Industry Council
The maximum risk is clearly established as the diagram shows while the potential gains are rather large and, in theory, are unlimited since prices can rise to extreme levels.
A Specific Trading Strategy
One ETF that could be used with this strategy is ProShares UltraShort 20+ Year Treasury (TBT). This ETF is an inverse trade on the long bond. It goes up in value as the value of the bond falls.
The chart below shows TBT is breaking out of a triangle pattern and the price target is at $42.45. This is about 5% above the current price. An option strategy, buying a call on TBT, could generate a significantly larger return assuming TBT moves up by 5%.
This could be a long term or a short term strategy. Since crisis are, by their very nature, usually unpredictable, we will consider it as a long term strategy since that would provide protection for an extended period of time.
A call option on TBT expiring on June 15 could provide extended exposure to the silver market. An option with an exercise price of $40 is trading at about $0.60.
Buying that call option would require $60 in trading capital since each contract covers 100 shares. This ignores the cost of commissions which should be small, totaling less than a few dollars at a deep discount broker.
The strategy diagram above shows that risk is limited to the amount paid to buy the option. In this case, the option loses 100% of its value if TBT closes below $40 on June 15.
If TBT closes above that price level, the option will have a value equal to the exercise price less the closing price. For a close at $42, for example, the option would be worth at least $2, and the call would deliver a gain of about 230%.
When this call expires, traders can enter another trade to maintain exposure to TBT. With this strategy, they would be able to maintain exposure to precious metals with a predefined, and relatively small, level of risk. An investor can never lose more than they pay when buying a call.
The long call strategy is an example of how options are a versatile tool and could meet many of your trading objectives. In this trade, options provide exposure to a market many traders otherwise ignore, the precious metals market.
They may ignore the market simply because they are priced out of it without the means to buy several ounces of gold. They may also ignore the market because it is inconvenient to buy and sell precious metals. ETFs solve those problems and do so at a low cost making them ideal for many investors.
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