US Interest Rates Put the Probabilities In Your Favor

By Tom Preston, TastyTrade.com

I’m a contrarian trader by nature, happier to bet against the crowd and sell when everyone else is buying, buying when everyone else is selling, It’s been tough being a contrarian in stocks lately, with the market rallying steadily for the past two months.  Hey, I thought AAPL was high when it hit $400.  Now it’s closing in on $500.  And that’s made me more cautious shorting equities.  But I’m finding the Treasury bond/interest rate market more interesting.

30-year Treasuries had a sharp run up last summer, and have basically been in a trading in a range between about 140:16 and 145:16 for the past three months.  They haven’t been able to sustain much of a rally, and while I don’t necessarily think bonds are going to crash, I think there’s more bias to the downside.  Now, remember the inverse relationship between bond prices and interest rates:  when rates go up, bonds go down, and vice versa.  So, if you think bonds might fall, you would think interest rates might go up.

If you want to trade US interest rates, a great product is the TBT, the ETF that moves 2x the change in interest rates of long-term Treasuries.  When bonds go down, TBT goes up. At the current price of $19, it’s trading just above lows of $18 and has been oscillating between $18 and $19.50 for the past couple of months, setting up what looks like a fairly strong bottom pattern.

As a professional trader, I like my strategies to have certain characteristics: a maximum possible loss that’s known before I do the trade, a high probability of making at least some money, and the possibility of making money even if my bullish directional bias is wrong.   A strategy that might work for interest rates is an out-of-the-money short put vertical.

Selling the March 18 put and buying the March 17 put to create a short put vertical for .20 credit is a position that makes money if TBT is anywhere above $18 by expiration.  What’s the benefit?  First of all, there's only an $80 capital requirement to hold this position.  That’s the margin requirement on a short vertical spread.  Second, TBT doesn’t even have to rally for the position to make money.  From the current price of $19, TBT can drop down to $18 and the short put vertical still makes money.  In fact, the break even price of TBT is $17.80.  Third, the max possible loss on this trade is $80, and happens if TBT is below $17 at March expiration.  No matter how low TBT goes, the most it can lose is $80.  Fourth, the probability of making money on this trade is about 80%.   I estimate that by taking the max loss of $80 and dividing it by the width of the strikes, $100. Fifth, if TBT rallies, or at least stays above $18, the position makes $20 max profit.  And that would give the strategy a 25% return on capital for just over a month.  That’s not bad for a month’s investment by a contrarian.

To learn more about this type of strategy, watch the free shows on the tastytrade network.

Tom Preston

www.tastytrade.com

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