Inflation has continued to remain well above Federal Reserve and analyst expectations. This has driven expectations for further interest-rate hikes.
While Treasury yields have surged — with the 20-year yield is now around 3.75% — investors who expect inflation to remain somewhat persistent in the long term can take advantage by selling a call on the iShares 20+ Year Bond ETF.
TLT is an exchange traded fund holding U.S. Treasury bonds of at least 20 years to maturity. The bonds perform inversely to interest rates. If rate expectations rise, TLT stock will fall and if rate expectations fall TLT's price will rise.
In this trade, an investor can sell a 110 call in TLT with a longer-dated expiry of August 2023. This call will provide a credit of 8.40, which also equates to a maximum gain of $840 on the trade so long as TLT stock (or rather ETF) is trading below 110 on expiry.
Options Prices Appear Inflated, Lead To Higher Premiums
This trade will earn a full profit if yields fall or stay constant. By selling this call investors are shorting volatility. The 110 call in August currently has an implied volatility of 20.5%, while TLT has only realized 17% and 18.5% volatility over the past 30 days and one year, respectively.
While there certainly is a lot of uncertainty over interest rates, rate shifts over the past year have been dramatic. If investors expect less or a similar level of volatility, these options are expensive.
The break-even price for the trade is 118.40. In the event of yields falling dramatically — which could be caused by inflation moderating quickly or a global recession leading central banks to lower rates — the potential losses are uncapped. Nevertheless, because rates in the U.S. are unlikely to drop below 0, the risk to this trade is limited.
The Federal Reserve will meet on Tuesday and Wednesday. The market is currently pricing in an 85% chance of a 75-basis point hike and a 15% chance of a 100-basis point hike. Nevertheless, as this TLT moves with longer-term rates, the overall rhetoric, projections and the federal bank's stance on inflation will be more important.
Traders Can Exit TLT Stock Trade Early
Because these options are longer dated, instead of holding until expiration, investors can consider taking profits early if their view is correct or close the position if the data they receive comes against their views. As the longer-dated options are somewhat illiquid, investors should use limit orders to both enter and exit positions.
Shares of TLT are reaching the lowest since early 2014, down over 25% year to date, and remain well below the 20-day, 50-day and 200-day moving averages.
