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Trading Bonds With Options

Trading Bonds With Options

Bonds seem simple to understand and trade but there is really nothing in the investment world so simple that a review of the concepts doesn’t prove to be helpful. The simple point about bonds is that prices fall as rates rise.

That is certainly simple but developing a strategy based on that insight could require some thought. Let’s start by reviewing some charts. The first chart shows interest rates on ten year Treasury notes since 1962.

interest rates on ten year Treasury notes

Source: Federal Reserve

As the chart shows, interest rates tend to move in long term trends that last for decades. From the early 1960s into the early 1980s, the trend was up. Since then, a period of more than 35 years, interest rates have been in a down trend.

The relationship between interest rates and bonds is shown in the next chart. Data for 10 year Treasury note futures dates back to 1982 in the chart.

ten year bonds

The trend has been up for more than 35 years. The chart above is a futures contract using a continuously adjusted price. That’s why prices with negative values are shown at the left side of the chart. This chart correctly shows percentage changes of prices but not actual prices.

Futures trade for a limited amount of time. As one expires and a new one becomes the current contract to trade, the prices of the two contracts will be different. To account for this, data providers adjust each contract when the old one expires.

In effect, each price from the past is adjusted to maintain a continuous data series whenever a contract expires. This eliminates price discontinuity and creates a data series that can be used to study historical trends and that is suitable for back testing trading strategies.

We are not using the data to back test a strategy, but we wanted to explain the chart for readers who may have noticed the negative prices and wondered about the accuracy of the chart. Percentage changes in the chart are accurate and the trend is accurate.

Trading After the Bull Market in Bonds Ends

Of course, there is no way to know when the trend will reverse. But, the chart above shows that, on average, interest rates on long term bonds have generally been significant higher than they are today. When rates start to rise, they are likely to move substantially higher.

The second chart above shows us that when rate move up, the long standing up trend in prices will reverse. Lower bond prices may surprise many investors and that could lead to additional selling pressure which will force prices down even more.

In other words, a decline could make further declines even more likely. While we don’t know when it will happen, we do know that eventually the multidecade bull market in bonds will end and a bear market will begin.

This means traders should consider buying a put option on an ETF that tracks bonds. This is one of the simplest options strategies available. Buying a put can deliver a gain if the price of the stock declines.

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 put. The risks and rewards of this strategy are summarized in the diagram below which is taken from The Options Industry Council web site.

long put

The maximum risk is clearly established as the diagram shows while the potential gains are rather large if a down trend develops.

A Specific Trading Strategy

Bonds with a longer time period to expiration will have larger price swings than bonds that mature in a shorter amount of time. That means to implement a strategy to benefit from a bear market in bonds, traders should consider bonds with an extended period of time to expiration.

iShares 20+ Year Treasury Bond ETF (NYSE: TLT) holds bonds with an average time to maturity of more than twenty years.  In fact, the portfolios weighted average maturity is now more than 25 years according to the fund manager.

If interest rates were to move up by 1%, the fund managers tell investors that they should expect the price of the ETF to fall by more than 17%. This means put options could provide significant gains to patient investors who maintain a long put strategy until the bear market begins and throughout the decline.

In contrast, an ETF with bonds that have an average of about five years to maturity are expected to lose about 4.4% in value if interest rates rise by 1%. This demonstrates the importance of selecting the right instrument for this strategy.

A put option on TLT expiring on June 15 with an exercise price of $118 is trading at about $3.00. Buying that put option would require $300 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 TLT closes above $118 on June 15.

If TLT closes below that price level, the option will have a value equal to the exercise price less the closing price. For a close at $114, for example, the option would be worth at least $4, and the put would deliver a gain of 33%.

When this put expires, traders can enter another trade to maintain exposure to TLT. This will accomplish the same objective as a long term option, such as the one expiring in January 2020 which is trading at about $8, but the short term option is available at a lower cost. That could benefit smaller traders wanting to benefit from long term trends.

The long put 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 fixed income market.

These are the type of strategies that are explained and used in TradingTips.com’s Options Insider service. To learn more about how to trade options to meet your goals, click here for details on Options Insider