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Taking Advantage of Interest Rates

Risky assets have taken the front stage as investors clamor to increase the yields within their portfolios.  Because of the flight away from quality, treasury securities have fallen slightly out of favor and 30 year yields have crept up to about 4.3%.  There have been many comparisons between the current US economic environment and that of Japan in the 1990’s and I want to explain where that comparison falls apart.  Japan entered their malaise as a country of savers whereas the United States entered its crisis with a heavy burden of debt.  That is a very important distinction that has swayed me towards a trade that I think has a very high probability of being right.

If we believe in any recovery in the world economy then I think it is safe to say that we will not see 30 year treasury yields hit 2.5% as they did on December 18, 2008.  Those yield levels were crisis levels.  That occurred when there was an extreme flight away from all risky asset classes and into safe assets such as treasury bonds and agency backed mortgage securities.  At the time, it did not seem that shorting treasuries was a “no-brainer” because we all know that the crisis would unleash many more months of pain.

Treasury securities sky-rocketed when there was a flight to quality

Treasury securities sky-rocketed when there was a flight to quality

The rising prices in risky world assets is a signal that risk-appetite has returned and fear has subsided.  Now is the time to assess what that means going forward.  The harsh reality is that the United States has a massive amount of debt and is currently paying very low interest rates for that privilege.   It is my opinion that will change, and it might even occur very rapidly if consumer demand picks up and inflation scares spike.  Betting that interest rates will increase can be done very easily by shorting treasuries (TLT or Bond futures) or by buying put options on those same underlyings.  I am not going to make that bet outright, instead I am going to take a more agnostic view and just make some bets on where interest rates should not go.  It is helpful to look at where yields were and what that meant for the price of the instrument I want to use to facilitate this bet.

Long rates hit 2.5% at the low and now hover well above 4%

Long rates hit 2.5% at the low and now hover well above 4%

Now that we have both the yield and price charts, we can make some statements regarding the relationship.  At a yield of about 4% the TLT (20+ year treasury ETF) traded at about 100 and at 3.5% TLT traded at about 106.  I believe that both of these levels provide good barriers to sell call options on TLT.

When I sell options I generally look at selling options that are 3-6 months out.  I find that a longer option gives you more breathing room so that you do not get stopped out of the position.  When selling very short options you get fantastic time decay (theta) but small changes in price can stop you out of a position more quickly.  This would lead me to recommend looking at March or June 2010 contracts.

100 and 105 strikes trade for 2.25 and 1.20 respectively

100 and 105 strikes trade for 2.25 and 1.20 respectively

If you sell these call options at the ask price, then you receive $2.25 for the $100 strike or $1.20 for the $105 strike.  This will pay you $225 or $120 per option sold as long as rates do not go lower than 4% or 3.5% by June of 2010.  I think this is a high probability trade.  If you want to make this more aggressive then you can look at selling the calls and buying put options.  That way the purchase of the puts would be partially paid for by the written calls.

I like this trade because it makes good economic sense and because it provides protection against a rising interest rate environment.  Remember that rising interest rates are generally bad for equities and very bad for fixed income investments, so you can view this as a partial hedge against your other fixed income assets.  The risk is that interest rates plummet as there is another flight to quality.  In that case all assets besides treasuries are declining and we probably have more important things to worry about.

Trading options in some brokerage accounts is expensive, so if you only have a Charles Schwab, E-Trade, or TD-Ameritrade account and are interested in trading options more often I suggest you open up an account at a specialty broker.  TradeKing is one of the best and the link at the top of your screen will take you to a special $50 promotion for opening an account.

Disclosure: Short TLT

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9 Responses

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  1. Randy Woods says

    Unemployment is still rising, our consumer driven economy is paralyzed, real estate prices in many areas are still looking for a bottom, banks are deleveraging (not loaning) – all deflationary signs. I’m betting US Treasuries rally, interest rates are lower next spring and summer and we have more important things to worry about.
    We can both express our opinions. That’s why we have markets.

  2. SurlyTrader says

    I do not disagree with your disinflationary environment one bit, but that is why I am not making a directional bet unless I am hedging fixed income investments directly. The reason that I believe interest rates will not go lower than 3.5% is because the federal reserve has made it pretty well known that they will do everything in their power to stop deflation. If they did not succeed in the massive intervention and liquidity of 2009, then they will be sure to prime the pump even more in 2010. If you give the banks enough liquidity, then they will start lending to everyone with a pulse once again – for better or worse.

    What’s frightening is that I am not even sure there will be a flight to traditional quality the next time there is an asset bubble correction. Next time investors might buy hard assets because they don’t want to have anything to do with US government debt when the government is already smothering in debt.

    But you’re right, we can have differing opinions and still be able to make our respective bets. Nothing is ever a slam dunk.

    Regards,
    SurlyTrader

  3. Randy Woods says

    When the world no longer has a bid for US bonds, the most significant hard assets will be canned food and ammunition. Ammo has done well lately.

Continuing the Discussion

  1. The Relative Strength of Countries – SurlyTrader linked to this post on November 5, 2009

    […] sense given the economic conditions.  Interest rates will not stay at their relatively low level.  That is why I recommended selling call options on TLT. Commodities (not just gold) diversify an investment portfolio and add protection against inflation […]

  2. Rising Interest Rates | SurlyTrader linked to this post on December 23, 2009

    […] In a debt burdened economy like that of the United States, interest rates are the lifeblood.  In a previous article, I suggested selling call options on TLT (long treasury ETF) under the theory that interest rates probably could not go much lower and it […]

  3. Interest Rate Outlook | SurlyTrader linked to this post on January 14, 2010

    […] to a debt burdened economy.  Back in October 2009, when 30 year treasury yields were at 4%, I suggested that getting short treasuries or selling call options on treasuries would be a good stra….  It turns out that I made a wise call, because since then 30 year rates have risen over 60 basis […]

  4. Interest Rate Outlook | Reaction Radio linked to this post on January 15, 2010

    […] to a debt burdened economy. Back in October 2009, when 30 year treasury yields were at 4%, I suggested that getting short treasuries or selling call options on treasuries would be a good stra…. It turns out that I made a wise call, because since then 30 year rates have risen over 60 basis […]

  5. Interest Rate Outlook | Stocks and Sectors linked to this post on January 16, 2010

    […] to a debt burdened economy. Back in October 2009, when 30 year treasury yields were at 4%, I suggested that getting short treasuries or selling call options on treasuries would be a good stra…. It turns out that I made a wise call, because since then 30 year rates have risen over 60 basis […]

  6. Testing the Rate Barrier | SurlyTrader linked to this post on March 8, 2010

    […] rates have behaved the way that I predicted long ago, but now we are at a turning point.  Is the rally real and can the economy actually sustain itself […]



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