Fighting The Fed With Bond ETF Options

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. More than 105 million options on ETFs were traded in May, and because ETFs and options are among the fastest-growing financial vehicles in the world, it makes sense to combine the two. This column highlights unusually large or interesting ETF options trades to help readers understand where traders believe a particular ETF may be headed. In doing so, Nations examines the underlying options strategy.

June has been a tough month and 2015 a tough year for the iShares 20+ Year Treasury Bond ETF (TLT | A-85). One big institutional options trader thinks things are going to get a little bit worse.

TLT provides exposure to long-term U.S. Treasury bonds, those bonds most impacted by changes in interest rates. Since Treasury bonds pay a fixed dollar amount of interest each year, as interest rates increase, the value of each bond decreases to keep the interest payment consistent with the current interest rate bond investors demand.

So, as interest rates have increased recently, TLT has fallen, as you can see by looking at a one-year chart:

TLT is down 6.5 percent in 2015 and down 4.8 percent in June alone, as investors in Treasury bonds have lowered the price they’re will to pay for those existing bonds in the portfolio, as they fear the Federal Reserve is about to start ratcheting up interest rates.

But rather than just sell all bond holdings and step to the side, one large institutional options trader has found a way to profit, rather than simply avoid losses, if TLT continues its slide through the summer.

Executing The Trade

On Tuesday, this trader bought 12,000 of the $115 strike TLT puts expiring in September. He paid $3.85 per share, and since each option corresponds to 100 shares of TLT, he now has the right, but not the obligation, to sell 1.2 million shares of TLT at $115.00 per share before these options expire on Sept. 18.

But $3.85 per share is pretty expensive, so to reduce the cost of the trade, our trader also sold 12,000 of the $111 strike TLT puts expiring at the same time. He received $2.20 per share for selling these puts, so the net cost for the trade was $1.65.

In buying a put option with the $115 strike price and selling a put option with the $111 strike price, our trader has bought a put spread, and stands to profit by the distance between the strike prices ($4 in this case), less whatever the trade cost ($1.65 here).

Analyzing Outcomes

It’s interesting that our trader bought a put spread expiring on Sept. 18. That’s just one day after the Fed’s September meeting. Right now, it seems that’s the meeting when the Fed will start raising interest rates.

By selling that $111 strike put and turning the trade into a spread, our trader has reduced the cost of the trade by 57 percent. The downside? He’s limited his potential profit, as you can see by comparing this trade and an outright purchase of the $115 puts:

The put spread is an unambiguously bearish trade: It can only be profitable at expiration if TLT drops below $113.35 at that September expiration. Our trader could close the trade prior to expiration, but it would be nearly impossible for this trade to be profitable without TLT dropping.

Similarly, buying an outright put is unambiguously bearish.

In fact, it’s more bearish than buying a put spread, since the outright put will continue to increase in value as TLT continues to fall. If you thought TLT was going to fall a little bit, you’d buy the put spread; if you thought TLT was going to fall a lot, you’d buy the outright put.

Expensive Habit

But buying outright puts gets to be very expensive. Over time, options cost more than they’re worth, just as your homeowners insurance costs you more than the pure value of the coverage. The extra pays your insurer’s overhead and provides a little profit.

Similarly, options tend to cost more than they’re worth. In this case, it’s the huge asymmetry of payoffs—an options seller can only make the premium received but can lose many times that—that causes options sellers to demand a little extra from options buyers. The best way to reduce this cost is to buy an options spread.

So there’s a trade-off: Buying the spread is cheaper, but it limits your potential profit. But our institutional trader is betting on a moderate drop, not a dramatic one, which makes the spread—which is 57 percent cheaper—the smarter trade.

At the time of writing, the author did not own any positions in the security mentioned. Follow Scott on Twitter @ScottNations.