An Opportunity in Bonds

02/09/2007 12:00 am EST

Focus:

John Bollinger

President and Founder, Bollinger Capital Management

John Bollinger analyzes the current volatility implications in the bond market and analyzes a couple of option strategies to take advantage of the opportunity. Here, he recommends a way to profit from his forecast of economic growth and rising rates...

"There is something very interesting going on in bond land; volatility expectations are being crushed. If you look at the options traded on a security, one can determine the amount of volatility that is expected. This is done by reversing the famous Black Scholes option valuation formula and solving it for the volatility that is implied by the existing prices of the options. When one scans the implied volatilities, or IVs, of a list of securities, two groups tend to stand out: Those with very high IVs in relation to their histories and those with very low IVs in relation to their histories. The high IV list is a source of ideas for selling volatility and the low IV list is a source of ideas for buying volatility. In essence, market predictions of very high and very low volatility are most often wrong.

"We have thought about the extremes in volatility, expected and historical, a great deal over the years. So when we see something like the crushed levels of volatility for $TYX, the yield of a 30-year treasury bond, we pay attention and look for opportunity. So how does one buy and sell volatility? The easiest way is simply to buy options, usually a position called a straddle, or perhaps a strangle.

"A straddle is the simultaneous purchase of a put and call option with the same strike price; the March 47.50 call and the March 47.50 put, for example. This is a bet that volatility will rise. A strangle is the same idea but it uses different strike prices for the options, such as a March 45 put and a March 50 call. To sell volatility, reverse those strategies. Oddly enough selling volatility is regarded as more dangerous, but we'd guess that more money has been lost by buying volatility than by selling it. Of course when buying volatility, one's risk is defined, but when selling volatility one's risk is open-ended.

"Not too long ago trading volatility was pretty esoteric; today it is mundane and many professionals have already moved on to other areas where there is more opportunity. Nonetheless, we see the crushed implied volatilities for long interest-rate vehicles as an opportunity and would consider buying volatility in the sector. As our view is for economic growth and more inflation, call options on long-term interest rates or puts on long bonds are of interest as well."

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