Bond Trading for Beginners
Bonds could be one of the more difficult financial concepts to grasp for beginning traders and students of finance. The price of a bond is in an inverse relationship to the yield of the bond, but they don’t move in perfect correlation. To break that down in the easiest terms, the price of the bond moves the opposite direction to the yield on the bond, but not with the same speed.
Bond yields have been in the headlines lately as the 10- and 30-year yields are making recent multi-year highs. The most liquid way to trade bonds is with TLT which closely mirrors the price of the 20-year bond.
TLT has been in a bit of a free fall over the last few weeks as yields have steadily risen (remember, they move in opposite directions). Today I’ll present two trade ideas that both have potential returns on capital of over 30 percent in only 38 days.
With TLT having been steadily dropping, this could be an opportunity for the bond ETF to mount a comeback. By selling the November 2018 111 Put and buying the 110 Put, you would take in a credit of $29 and have a max risk of $71. As long as TLT stays above the 111 Put strike by expiration, this trade would provide a 40.8 percent return on capital. There’s a good chance of that happening as the 111 Put has a delta value of 32, meaning it has only a 32 percent probability of being in the money, or a loser at expiration, which means it has a 68 percent probability of producing profits in your portfolio.
Or maybe you think that TLT will continue to fall as rates continue to rise. The Fed is expected to continue to raise rates after all, so this doesn’t seem too far of a stretch. By selling the 115 Call and buying the 116 Call, you would take in a credit of $26 and have a max risk of $74, providing a potential max return on capital of 35.1 percent and still having a 68 percent probability of profit.
By using options to trade bonds, we can structure a bullish and bearish trade that has nearly the same probability of profit and both have a similar risk to reward profile. Want more reward? Just take on more risk. Trading small however allows your portfolio to absorb the hits in case you are wrong. I usually only risk about 1 to 5 percent of my portfolio in a single trade. I would much rather be wrong and have 95 percent of my portfolio unaffected than be wrong and left with only 5 percent of my portfolio remaining.
Bond Trade Ideas Recap
Expiration: November 18, 2018
Bullish Strikes: Sell 111 Put, Buy 110 Put
Bearish Strikes: Sell 115 Call, Buy 116 Call
Trade Price: $29 Credit (Bullish), $26 Credit (Bearish)
Total Risk: $71 (Bullish), $74 (Bearish)
Breakeven Points: $110.71 (Bullish), $115.26 (Bearish)