Playing for a Bond ‘Bounce’ without ‘Betting the Ranch’

  • SumoMe

Disclaimer/Caveat/Warning: The idea I am going to discuss here is definitely not for everyone.  As traders and investors we are told time and again that it is “foolish” to attempt to “pick tops or bottoms” in the financial markets.

And generally speaking, that refrain is spot on.  Still, part of being a trader is developing the ability to make money in ways other than just “buying and holding for the long-term”.  So the counter argument put forth is that it is OK to “speculate” as long as you don’t “bet the ranch.”  Let’s look at one example.

See also One Answer to the Large-Cap/Small-Cap Argument

Treasury Bonds

As you can see in Figure 1, long—term treasury bonds have been (and technically still are) in a freefall (down roughly 15% since July). 1Figure 1 – TLT plunging (Courtesy AIQ TradingExpert)

Conventionally wisdom would suggest that the dumbest thing a person could do right now is to try guess when bonds are going to bottom out.  And I concur that trying to pinpoint the “exact low” with any accuracy is essentially not possible.  But I have also seen enough freefall declines in my time followed by a “bounce” to know that money can be made quickly if and when the bounce comes.

So what if a trader (preferably one who has taken speculative positions before and understands the potential psychological “kick in the head” that can accompany a speculative trade that fails quickly) thinks that jut maybe bonds will ”bounce” between now and the end of the year.

Should he, a) turn away quickly and let the notion pass?  Or b) enter a speculative, limited risk trade?

The answer to that question is not for me to say.  But choose wisely.  Let’s look at one hypothetical possibility using options on ticker TLT – an ETF that tracks the long bond.

The Trade

*Buy 14 TLT DecQ4 116.5 calls @ 1.96

*Sell 21 TLT DecQ4 118.5 calls @ 0.98

*Buy 7 TLT DecQ4 120.5 calls @ 0.43

The particulars appear in Figure 2 and the risk curves in Figure 32Figure 2 – TLT DecQ4 Option trade (Courtesy www.OptionsAnalysis.com)

3Figure 3 – TLT DecQ4 Option trade risk curves (Courtesy www.OptionsAnalysis.com)

As you can see, this trade stands to:

a) Make money if TLT bounces higher between now and the end of the year

b) Lose money if TLT continues to trend lower

Managing the Trade

This is not a “set it and forget it” trade.  A traders actions going forward is very much dependent upon what happens to the price of TLT.  Let’s talk first about risk management.

The risk on this hypothetical position is -$987.   If TLT is below $116.50 at the end of the year that would be the maximum loss. As you can see, dollar risk increases sharply with time decay as options expiration (the black line risk curve) approaches.  If TLT trends lower and does not appear likely to get back above the breakeven price, a trader might consider cutting his or her loss in the last week or so prior to expiration (although also note that the last 5 trading days of the month are often when bonds rally the most).

On the upside, this trade would make money with TLT at any price above $117.21. As long as TLT holds above that price (assuming of course that it ever even gets above that price between now and then) a trader could hold the position and exit soon before the close.

Summary

Is this a trade that everyone should rush out and put on?  Not at all.  In fact as always please not that this is not a recommendation.  The truth is that this is the kind of trade that can make you look  really stupid really fast.

Like I said at the outset, it’s not for everyone.  This piece is intended to serve simply as an example of one way to speculate with limited risk.

Jay Kaeppel

 

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