Having an Interest in Rates

Sean McLaughlin
December 19, 2018

Bonds funds did a good job of getting everyone on the boat leaning one way, only to reverse and slam them in the other direction. The whole world seems to think interest rates have no where to go but up. However, those of us who follow the price of bonds know that reality has been sending us a different message.

The recent failed breakdown in $TLT (the 20-year bonds ETF) is a perfect example

:

That was a pretty nasty reversal off October lows. Now, and more interestingly, the chart of $TLT finds itself negotiating with a longer term down-sloping trend line.

On Monday, JC had this to say:

If we’re above 119 in $TLT, then I think we need to err on the long side of bonds and expect further downside in stocks. Bonds failing up here would likely be more consistent with an environment that stocks are going higher. So I think this is a big one to watch.

Well, since this writing, we've gotten our close above $119 for $TLT and it feels like a breakout above this trend line is beginning to take shape. It could be a sloppy process and options volatility is somewhat elevated here so we're going to limit some of risk with a bullish vertical call spread.

Here's the Play:

We're going to buy a March 120/123 Bull Call Spread for an approximate debit of $1.10. This means we'll be long the March 120 calls and short an equal amount of the 123 calls. I considered just buying straight naked long calls, but the options premiums are somewhat high and so I wanted to limit my risk. Selling further out-of-the-money calls accomplishes this. Additionally, I chose the 123 strike to sell because that level has been tested numerous times this year and $TLT failed to follow through each time. And finally, I chose the March expiration options because that gives us plenty of time for our thesis to play out. I like that.

The goal of this spread will be to make about $1.00. The most we can make in this trade is about $1.90-2.00, but I'm not greedy and won't be holding forever trying to squeeze those last nickels out of the trade. When I can close it for a $1.00 profit, I'm out.  So, if we initiate the trade for a $1.10 debit, we'll look to close it for around a $2.10 credit.

Since this is a defined risk spread, there will be no reason to panic or manage this trade if it goes against us. We fully accept that we'll lose all of the $1.10 we paid up front if this trade doesn't work out. Therefore, we'll size our position accordingly.

~ @chicagosean

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