Most people think bonds are boring. And it’s true, if you buy a bond and just wait for the coupon payment to arrive, it is definitely an uneventful investment… boring and safe. Of course, that’s exactly why people buy bonds.
However, trading bonds is a completely different matter. Bonds, even government bonds, can move as much as stocks do during the trading day (although this isn’t the typical situation). As such, trading bonds can be as profitable as trading stocks in the short-term.
It’s also true that bond volatility (whether it be government bonds or high-yield bonds) is often lower than stock volatility. But that just means the options on these types of assets can be very reasonably priced relative to stock options.
Traders can utilize the same options strategies with bonds as they do with stocks. After all, most traders use ETFs to trade bond products rather than the bonds themselves (or bond futures). Plus, there are several extremely popular bond ETFs that are used abundantly in investment portfolios of all types.
One of the most popular is iShares 20+ Treasury Bond ETF (NASDAQ: TLT) which trades about 10 million shares a day and another 70,000 option contracts. TLT tracks long-term treasury bonds, which means it’s a proxy for long-term interest rates in the US.
Here’s the deal…
Interest rates are expected to increase in 2018, with the Fed currently planning three rate hikes this year. The number or magnitude of those increases could rise in the coming weeks due to economic data. Or, there could even be a preemptive rate increase due to potential inflation. (If that happens it will be in part due to the tax break windfall individuals and corporations are expected to receive.)
Lately, the idea of rates going up faster than expected is starting to take hold among traders. We’re definitely seeing an increase of bearish action in TLT options. Keep in mind, higher rates mean lower bond prices, so TLT will go down as rates go up.
Just this past week, a size trader purchased 10,000 TLT March 118-122 put spreads (buying the 122 put, selling the 118 put) for $0.89 with the stock around $124. This trade breaks even with TLT just above $121, and hits max gain at $118. The cost of the spread was around $900,000, while max gain is around $3.1 million.
That’s clearly a substantial amount of money at stake. However, I believe it’s a very smart option trade. A 3.5 to 1 ratio (payout to cost) favors the spread buyer (and it breaks down to over 200% profits at max gain). Moreover, it’s really difficult to see interest rates do anything but go down. Unless the economic environment changes substantially, there’s a very good chance this trade is going to pay out.
In fact, I recommend doing this exact trade. It’s an affordable strategy and has a good payout. Plus, it buys a couple months of time, which is more than enough to get an idea of what the economy is doing.