From the January 01, 2012 issue of Futures Magazine • Subscribe!

Options spread that locks in your risk

Options Strategy

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.

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