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SK OptionTrader Banks 15% in 17 days From Treasuries Short

On March 20th 2011 SK OptionTrader sent an update to subscribers explaining that we felt the large rally in US Treasuries was overdone. We felt that yields, particular at the long end of the curve, were too low.

We then detailed how we intended to use options to modestly profit from a rise in yields/sell off in Treasuries in the coming weeks.

We then sent a signal confirming what trade we had placed and 17 days later that position was closed for 15% gain. This is the 67th winning trade we have recommended from a total of 69, with the average return per trade being 40.85% and the return since inception on our model portfolio is now 250.28%

US Yields

The following is an excerpt from an update we sent to SK OptionTrader subscribers on March 20th 2011:

We are also planning to take a short position on US treasuries. We hold the view that the recent rally in US treasuries has run its course and yields going out past 5 years are set to rise. With this in mind we intend to sell vertical put spreads on TBT (Proshares Ultrashort 20+ Year Treasury) and PST (Proshares Ultrashort 7-10 Year Treasury) this week, targeting April or May expirations. This will result in a short position since they are both inverse treasury ETFs. The trades should book a modest profit if the US treasury market falls or goes sideways in the next month or so.

Let us explain the basic mechanics at work in this trade. Firstly the price of a bond moves inversely from its yield. Therefore if yields are going to rise that means prices are falling. If prices rise, yields fall. Therefore when one refers to a selloff in the bond market that means yields are rising. When there is a rally in the bond market that means yields are falling.

TBT and PST are leveraged inverse ETFs, which means their price moves in the opposite direction of the underlying assets by a factor of 2. So if the underlying asset decreases by 1%, they should rise by 2%. We didn’t end up placing the trade on PST due to the large bid/ask spread on PST options that was observed that week, but we did place the TBT trade so we will focus on that.

US Treasuries had experienced a large rally in part due to safe haven buying in the aftermath of the tragic events in Japan. We felt this rally was overdone and yields were too low, especially on longer term US government debt. Therefore we wanted to benefit from a selloff in those bonds as investors unwound positions bought in the panic following the Japanese quake.

US 30s Price Chart

If we were correct that US Treasuries would sell off, that would mean that TBT would increase in price significantly. We therefore wanted to express our bullish view on TBT via options. We contemplated buying call options on TBT, which would have been the simplest way to play the move. However we decided against call options for two reasons.

Firstly we were concerned that the selloff in treasuries could be a gradual process, rather than a sharp snap back. In this case call options would not have performed very well since implied volatility would have been decreasing and the decay of the time premium in our call option would have eaten into potential profits. Secondly there was the possibility that the market could drift sideways for a couple of weeks, which would have decreased the value of call options again due to the decay of time premium and the reduction in volatility.

We therefore decided to execute a vertical put spread, a strategy whereby we sell a put with a high strike price and buy a put with a lower strike price, both with the same expiration. Since the higher strike put commands a larger premium, this transaction results in a net credit. We sold $35 April puts for $0.40 and bought $34 April puts at $0.24, giving us a net credit of $0.16.

The maximum loss on this trade is limited to the difference between the strikes; $1. So the maximum profit we could make on the trade was 16%.

The basic view expressed by the position is that TBT will rally, go sideways or simply stay above $35. If that happens then both put values go to zero and we get to keep our $0.16 net credit.

Trading signals are sent whilst the market is open and at prices that are available in the market at the time the email is sent.

On March 21st we sent the trading signal to subscribers saying:

Further to notice in our previous update, we hereby signal to Sell TBT Apr 16 '11 $35/$34 Vertical Put Spread at $0.16 with 10% allocated to this trade.

However profits can be realised more quickly if TBT rallies, since it becomes less likely that the $35 and $34 puts will be worth anything come expiration. Therefore the spread between them narrows as both prices move to zero. In the case of this trade, TBT did rally and the spread narrowed to $0.01 so we took our 15% rather than holding out for 16%.

TBT Vertical Spread

The graph above roughly shows how the spread narrowed during the duration that we held it. As one can see, the spread between the puts narrowed, from 16 cents to 1 cent, where we closed the trade.

The trade was then closed on April 8th when we said:

We hereby signal to close our short position on US Treasuries, and we have bought have the vertical put spread we sold at $0.16 for $0.01.
This trade has given us a 15% return in 17 days.

As we have previously mentioned, this does not reflect a change in our view on the US bond market. This merely means we do not think it is worth holding out for an additional 1% profit since there is still a significant event risk to the position. Event risk would entail risks such as the Japanese earthquake, a unpredictable event that caused a sharp rally in Treasuries in a flight to safety, which would hit our position particularly hard since the put spread we have sold is on a 200% inversely leveraged fund.

TBT Chart

At SK Options Trading our focus is to consistently make profits and identify trading opportunities in the options market that offer attractive risk-reward dynamics. Our trades are not limited to gold and silver, even though that is currently our main focus, so if we see opportunities in other markets we will certainly take them as we did here taking a position on long term US Treasuries.

After all even if one if is just trading one asset, such as gold, one must still consider the entire macro environment and the affects other markets could have on gold. Therefore if one sees opportunities in other areas as part of this study then it makes sense to seize those trading opportunities.

If you would like to sign up to SK OptionTrader then you can do so by clicking one of the buttons below.

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