Question: How can you take advantage of a sure thing, when you are not sure of the timing and volatility?
Answer: Execute an options spread that locks in your risk.
Some market moves can be predicted easily in the long run but can’t be exploited because of short-term volatility. Seeing the opportunity in front of your nose is not enough to profit from it — you also have to know how to trade it.
Traders expected that the Gulf War (I) would have a dramatic but probably short-term impact on crude oil prices in January of 1991. Apple likely would skyrocket once Steve Jobs came back as CEO, and interest rates obviously would be lowered during the 2008 banking crisis.
Some events are easy to spot but not easy to exploit. The best example is the Tech Bubble of 1997-2000. It left many astute traders bankrupt as they shorted stocks prematurely and couldn’t hold on for the inevitable turn. Imagine shorting AMZN at $211 on Nov. 30, 1999 and seeing it trade at $477 on Jan. 3, 34 days later. A position short100 shares would have cost $26,600.
Could you have held out another year until Dec. 19, 2000, when the stock got down to $28? Not on a naked short. Being long or short stocks can have unlimited losses if you are wrong, yet a strategically executed option strategy can predetermine acceptable risk characteristics for a specific time frame.
Even casual observers of mortgage rates and the U.S. government’s interest rates can see that these rates likely have hit a bottom and eventually will rise. Standard & Poor’s rating agency has downgraded U.S. government debt once and they and other ratings agencies are considering a further downgrade. While U.S. Treasuries sloughed it off the first time, that is not likely to continue. If the economy is indeed coming out of its stagflation period as many believe, then raising interest rates will be one of the first tools that the Federal Reserve will use to stave off inflation.
The 10-year Treasury note is yielding less than 2%, which translates to an all-time high in prices. The Federal Reserve has maintained a zero interest rate policy since late 2008 and though its "Operation Twist" is attempting to keep yields down on the long end of the curve, it is running out of bullets. For these reasons, the likelihood that rates will move higher in the future is strong. But you could have said the same thing a year ago and would have been wrong, similar to the Tech Bubble in the late 1990s. Therefore it is important to define your risk before entering a position.
If you are uncomfortable or prohibited from accessing options on bond futures, you can utilize highly liquid exchange-traded funds (ETFs). One of the more liquid ETFs is the TLT, or Barclays iShares 20+ year Treasury Bond Fund. What is easy about the TLT is that it moves in the same direction as bonds. Thus, if you are bearish bonds you would enter a short position, short calls or a call spread or go long puts or a put spread.
Futures traders can trade options on the 10-year. If you are more comfortable with the ETF, you can estimate how much the TLT will move based on yields in the 10-year. From 2007 to the present, the TLT rallied roughly 15 points ($14.81) for every 1% drop in yield. This is not a perfect metric because of changes in the yield curve and other variables, but it is a good rule of thumb.
For example, from March 31 to Aug. 31 yields fell 1.23%, from 3.45% to 2.22%. In that same period, the TLT rose $14.90, from $92.13 to $107.03. Obviously it should have been slightly higher given the generalization.
Say we expect yields will climb by at least 1% in the next six months as the economy improves and shows signs of inflation. With the TLT at $119.75, we would expect it to drop to at least $104.75. Choosing the September 2012 (199 days until expiration) 115-105 put spread will cost $3.65 (115 put at $6.80 - 105 put at $3.15 = $3.65). If our assessment is correct and the index closes at ≤ $105, the $10 wide spread will be worth its maximum of $10 (see "Defining risk/reward").
The maximum loss would be our $3.65 investment, and our profit potential would be $6.35 ($10 – $3.65), or a return on investment of 174%. Compare the put spread, which has a margin of $365 per 100-share spread, to selling 100 shares at $119.75, which will incur a margin of $5,990. If the index went down $15, you would make $1,500, have massive risk and only receive a 25% return. The choice is pretty simple.
M. Burkhardt is the CEO of option education firm RandomWalk Trading. Additional educational material is available at randomwalktrading.com.