I wrote last week about the pitfalls of relying on “conventional wisdom” (in a nutshell, it is wrong way more often than you might think, especially when it comes to the financial markets). Speaking of conventional wisdom, haven’t we kind of gotten used to interest rates of about zero? No reason to expect that to change anytime soon, right? So not much risk in t-bonds, right? Well, perhaps. However, as I also wrote about on 12/29/2011 http://www.optionetics.com/marketdata/article.aspx?action=detail&aid=24165, t-bonds have displayed a seasonal tendency to decline during the first four months of the calendar year. So is there an opportunity brewing? Let’s take a closer look.
T-Bonds by the Calendar
Figure 1 displays the annual seasonal tendency chart for t-bonds. Of current interest is the period extending from the end of January trading day number 12 (January 19, 2012) through February trading day number 14 (February 21, 2012).
Figure 1 - T-bonds about to enter a “seasonally unfavorable” period
Clearly this has been a seasonally unfavorable period on balance over the past 30 years. That being said, please note that there is an important difference between the phrases “seasonally unfavorable” and “bonds will absolutely, positively decline during this period this year.” Figure 2 displays the grain or loss generated by holding a short position in t-bond futures between January trading day number 12 and February trading day number 14 every since 1978.
Figure 2 – Gain from shorting t-bond futures from January TDM 12 through February TDM 14 (1978-2011)
Two obvious takeaways from Figure 2:
1. The long-term trend during this period has clearly been bearish, however.....
2. This is no “sure thing” (t-bonds have declined 24 times – or 73% of the time - but have risen 9 times, or 27% of the time).
Nevertheless, this seasonal trend serves as our first “warning sign”.
T-Bonds by the Chart
Figure 3 displays a daily bar chart for ticker TLT (the exchange-traded fund that tracks the 30-year t-bond). As you can see, there are a few concerns from a technical analysis point of view. The red line highlights the fact that TLT has tried several times to take out the 123-125 resistance level – so far to no avail. Typically when a security tries repeatedly to break through a certain level and fails, it eventually runs out of steam and the next move is in the opposite direction. There are also several triangle and wedge patterns in the process of forming, which could also foreshadow a “exhaustion” phase.
Figure 3 – TLT appears to be building several potential “topping” formations
So What to Do About All This
There are several parts to every new trading idea:
1. First there is deciding whether to be bullish or bearish (in this case we are examining the bearish side of t-bonds based on an unfavorable seasonal trend, a potentially bearish chart and a great deal of complacency on the part of investors regarding t-bonds).
2. Next is deciding whether this will be a major commitment in terms of trading capital or not. In essence, the question is “how much risk should I take?” In this case we are not going to “bet the ranch” and will use options to enter a position that entails a relatively small dollar risk if we are wrong, but which also enjoys excellent profit potential if we are correct and t-bond prices decline
3. The next step is deciding which actual position to enter. In this case I am going to consider a put butterfly using put options on TLT. The standard butterfly is entered into in a ratio of 1 by 2 by 1 (meaning simply one buys a put option at one strike price, sells two puts options at a lower strike price and buys one more at an even lower strike price). In this case, however, I am going to use a ratio of 2 by 3 by 2. The reason for buying one extra put option is to create a position that enjoys unlimited profit potential. Figures 4 and 5 highlight this position.
Figure 4 – TLT Put Butterfly (2 by 3 by 2)
Figure 5 – TLT Put Butterfly (2 by 3 by 2)
4. The final step is deciding how to manage the position and to decide in advance what might cause us to exit or adjust the position. In this case, if TLT does break out decisively above 125 we can consider exiting the position (or since the dollar risk is only $248 we could simply “let it ride” just in case the breakout proves to be false).
Another key consideration from Figure 5: If you look at the difference between the green risk curve line (that represents the expected profit or loss as of 2/25/2012) and the black risk curve line (expiration at 3/16/2012) we can see that after 2/25:
-Time decay will help this position if TLT is below roughly 110.83.
-Time decay will hurt this position if TLT is above roughly 110.83.
-So if this position shows a profit as of 2/25 and TLT is above 110.83 we might consider simply taking an early profit or somehow adjusting the position to mitigate the potentially negative effect of time decay.
-If TLT is below 110.83 as of 2/25 we might instead consider taking a partial profit and letting the rest ride.
Summary
So will t-bonds really decline during the seasonally unfavorable period coming up? Or will the party in bonds continue with TLT breaking out to a new high above 125? Unfortunately, there is of course no way to know for sure. Still, with several seasonal and technical indicators appearing to paint a bearish picture – and with investors quite complacent about the potential downside risk in t-bonds – “risking a couple of bucks” on the short side seems like a reasonable idea.
As always, the position I’ve highlighted here is not a “recommendation.” It simply serves as an example of how to enter a low-risk position in order to play a hunch in the markets based on a confluence of seasonal, technical and sentiment factors.
Is this stuff fun, or what!?
Jay Kaeppel
Staff Writer and Author of “Seasonal Stock Market Trends”
Optionetics.com ~ Your Options Education Site
NOTES:
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