Strategy for a long bond top

November 16, 2016 01:00 PM
What to do if/when interest rates start rising? Buy an out-of-the- money put butterfly.

In 2008, the U.S. economy hit its roughest patch since the Great Depression nearly eighty years earlier. Only the inflationary spiral of the late 1970s followed by the sharp recession of the early 1980s can compete with it. In reaction to that inflation, the Federal Reserve, led by then newly appointed chairman Paul Volcker, raised the Fed Funds rate as high as 20% in March of 1980 and January of 1981. The Fed Funds Rate is the rate that depository institutions lend out to other depository institutions overnight, with funds that are maintained at the Fed. The higher the rate charged by the Fed the more painful it is to borrow. During inflationary times, when the rate is raised money turns over more slowly and inflation then cools off, or so goes the plan. 

The converse is true during deflationary times. Lending seized up at the beginning of the Great Recession in September 2008. By December 2008 the Fed lowered the rate to a range of zero to 0.25%. It stayed there for seven years until the Fed raised the rate a quarter point in December 2015; 2016 was expected to be a year of multiple quarter-point rate hikes. So far, no rate hikes have occurred. The strategy behind all of this is called the “wealth effect.” 

If interest rates are held low enough for long enough, then assets such as stocks and real estate will increase in value so that the holders of those assets will feel comfortable enough to start an investment boom. Unfortunately, the velocity of money has not increased much and the growth of the GDP has consequently been sluggish. That is why the Fed has been so reluctant to raise rates. The median rate from 1971 to 2016 was 5.85%. The holder of a 6% bond would double their money every 12 years. The current coupon of a 30-year U.S. Treasury bond is 2.25%. Your money would double every 32 years at that rate. The yield for that bond is currently 2.475%. That means that it is selling below par due to expectations that interest rates will rise. 

In June of 2007, the Fed Funds Rate was 5.25%.  The iShares 20+ year Treasury bond (TLT) is the exchange-traded fund (ETF) that tracks U.S. Treasury bonds that have a maturity of greater than 20 years. On June 1, 2007, it was trading below par at 85.17. On July 8, 2016, TLT was trading at 143.62 (see “Blow-off top?” below). That’s what happens when interest rates hit rock bottom.

Now, let’s look at what happens when you want to take advantage of a rise in interest rates. The next rate hike is expected to take place this December. 

If it doesn’t happen at that time then it may never happen. With TLT trading at 132.90 you would want to look at some lower strike puts. You can look at buying 10 TLT December 126 puts for 0.93 (see the chart of a simple short below). 

The breakeven point for this trade is at 125.07. 

At 126 or higher the puts will go out worthless and you will incur your maximum loss of $930. Your loss will increasingly diminish between 126 and 125.07. If TLT fell to 114 you would have a profit of $11,070. Profits would continue to increase all of the way to zero.

To reduce your maximum loss of $930 you could sell an equal amount of December 122 puts for 0.40 (see the example of a covered short below).

You have converted your long puts into a bear vertical put spread for a debit of  0.53. Your maximum loss is now $530. Additionally, you can stay in the trade longer since the decay in your long December 126 puts is being counteracted by the decay in your short December 122 puts. Your new breakeven point is also closer at 125.47. While your maximum loss is being reduced, your maximum profit is also being reduced as a result of spreading off your long puts. The maximum value of the spread is the width of the two srike prices, in this case 4.00. Below 122, your shorts negate any further gains in your longs. This means that your new max profit is $3,470 at 122 or lower. 

You can reduce your maximum loss further by selling the December 122-118 bull put spread for a 0.22 credit (see the example of a bearish butterfly below).

Your debit on the combined spreads is now 0.31 for a max loss of $310. Your maximum profit is now $3,690 at 122, where your long spread is at maximum value and your short spread is at its minimum value. This is called a butterfly spread. You have two breakeven points at 125.69 and 118.31. The graph in the butterfly looks like a short straddle but you have the wings to define your losses.

About the Author

Dan Keegan is an experienced options instructor and founder of the options education site optionthinker.