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posted on 28 July 2016

Options On Bonds?

by Russ Allen, Online Trading Academy Instructor

Online Trading Academy Article of the Week

Many people think of put and call options as applying to stocks. But most exchange-traded funds also have available options. This includes ETFs that represent assets other than stocks - including bonds.

For example, the ETF called TLT owns 20-year and 30-year U.S. Treasury bonds. Owning shares of TLT means indirectly owning those bonds. On the first of each month, the fund management sends out a check (or a credit to your brokerage account) for the interest earned on the bonds for the previous month.

The prices of those government bonds are pretty volatile. This might seem odd, but in fact, the long-term treasuries do change in price quite a bit. This is partly because of their long-term maturities magnifying differences in interest rates over many years of remaining payments.

But apart from that, US treasuries have a special status as the ultimate destination for a flight to safety. When investors anywhere in the world are worried about the value of other kinds of investments they hold, some of them will sell those assets and look for a safe haven for the money. The save haven investors often choose are Treasuries. When they think the storm has passed, they will sell those treasuries and buy riskier assets again.

This pushes the prices of US treasuries up and down pretty significantly. And that volatility leads to a lively market in the put and call options on TLT.

Below is a weekly chart of the price of TLT over the last few years:

Options strategy for trading bonds

Note that TLT has traded across a broad range; at one time (last week) over 60% higher than five years ago. It has had its share of big drops too, as in 2009-10 when it lost almost 30% of its value.

So the prices of treasuries can certainly drop as well as rise. And being currently at all-time high price levels (which translates into all-time low interest yields), there is little or no room left to the upside.

Is there? Well, maybe. After all, it was also true that TLT was at all-time highs in 2008, and again in 2011, 2012 and 2015. Each time, most people thought their prices couldn't possibly go any higher, and yet they did. At some point, the prices of bonds could go so high that people who buy them get a negative yield - they are paying the government to borrow money from them. Can this happen?

It is happening already in Japan, Sweden, Switzerland, Denmark and for borrowers from the European Central Bank. So it's not a slam dunk that U.S. Treasury bond yields are as low as they can get.

But suppose that you believed that U.S. treasuries had finally peaked out and would drop in price from here. You could sell the ETF short. That's one of the great things about ETFs - you can treat them as if they were a stock, including selling them short. Nice, but like all short positions, that one would have unlimited risk. We know that bond yields have to rise, and therefore that bond prices have to fall - but when? And how much higher might prices go before then?

Profiting From a Drop in Bond Price & Managing Risk

So, how do you profit from a drop in bond prices if it does occur, without being hammered too badly if the impossible happens again?

Option strategies could be an answer. Using a small amount of risk capital for bearish option strategies on TLT will pay off well if bonds do drop in price within their expiration timeframe. Many option strategies have inherently limited risk. This includes the simplest bearish strategy of all - buying longer-term put options. Puts go up in value when the price of the underlying asset goes down. If the underlying asset rises in price instead, the puts will lose value. But the amount risked is only the price of the puts, which is a small fraction of the value of the ETF. This is in contrast to the unlimited risk involved in selling the ETF itself short.

Besides the simple buying of puts, there are other bearish option strategies to explore.

My point today is that options can be used to speculate on bonds in a limited-risk strategy. In fact, this applies to all sorts of assets through the use of ETFs.

Expand your horizons and look into the possibilities provided by options and ETFs.

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