Big TLT Put Purchase Bets On Big Decline

This is a weekly column focusing on ETF options by Scott Nations, a proprietary trader and financial engineer with about 20 years of experience in options.

Our bond market has been overlooked during the past two weeks thanks to volatility in equity ETFs. But the important question, the domestic question that is fueling our equity volatility, is when will the Federal Reserve start raising interest rates? That question impacts our bond market directly.

The iShares 20+ Year Treasury Bond ETF (TLT | A-85) focuses on the longest end of the yield curve by tracking U.S. Treasury bonds with remaining maturities of 20 years or more. Since longer maturity bonds are more sensitive to changes in interest rates, TLT is more volatile than ETFs that track shorter maturity bonds.

Has TLT Peaked?
You can see from the long-term chart that TLT rode the wave of Fed-induced lower interest rates and quantitative easing.

But now that the Fed has ended quantitative easing and appears ready to begin normalizing interest rates this year, TLT has come off its recent high of more than $136 per share, adjusted for distributions.

One large institutional option trader on Wednesday was looking to profit from further declines in TLT.

Our trader bought 4,400 of the TLT $120 strike put options expiring in January 2017. He paid $11.90 per share, or a total of $5.2 million, and he gets the right—but not the obligation—to sell 440,000 shares of TLT at $120 per share anytime between now and the expiration of these options in January 2017.

Options Like Insurance
Buying put options is just like buying insurance. The price paid is the premium. It’s no accident that the payment you make for your homeowners insurance and the price paid by an option buyer share that term.

There’s also a deductible. TLT was trading at $121.40 when our trader bought these puts, and the difference between $121.40 and the strike price of the options, $120.00, is the deductible and, unlike insurance, our put buyer doesn’t have to own the underlying asset—TLT, in this case—meaning he will profit if TLT drops.

Below $120.00, his “insurance” will begin to pay off, although there’s no guarantee that TLT will be low enough at option expiration to cover the cost of the insurance.

TLT will have to be at $108.10 for our trader to break even. Below there, his put purchase will be profitable. Of course, he might close the position at any time prior to option expiration by returning to the market and selling the puts.

You can see the payoff profile for these options below. While TLT has to fall below $108.10 for the trade to be profitable if the options are held to expiration, below there, the profit continues to grow as TLT continues to drop.

As with any long option position, the maximum loss is the amount paid for the options—$11.90, in this case.

Betting On Big TLT Decline
This trade contemplates a significant decline in TLT over the next 16 months and requires a significant investment on the part of the put buyer. That $11.90 paid is nearly 10 percent of the value of one share of TLT.

But TLT rallied convincingly during the financial crisis, and again when quantitative easing was in place. It’s easy to see why our trader would think it might fall just as convincingly.

Another interesting aspect to this option trade is the daily erosion. Longer-dated options like these puts tend to experience less daily erosion than shorter-dated options.

Daily erosion is the real price paid by the owner of the puts. Remember that our trader could return to the market and sell them at any moment. This difference in daily erosion is one reason some traders like to buy longer-dated options even if they have a shorter time horizon: They can always return to the market and sell the options, having experienced less daily erosion, when their time frame is reached.

Our trader is paying a substantial amount for these puts—more than $5 million—and is looking for a substantial move. We’ll revisit the trade in the future to provide updates.

At the time of writing, the author held no positions in TLT. Follow Scott on Twitter @ScottNations.