Don’t Fight the Trend in Bonds

08/24/2010 12:01 am EST

Focus: STRATEGIES

This statement is clearly the mantra of bond bulls, who have been served well as 30-year treasury futures are trading at their highest levels since the panic buying seen in early 2009. Weaker-than-expected economic data last week sparked the latest buying spree, with rising initial jobless claims and a weak Philadelphia Fed survey acting as the fuel for higher bond prices. It appears that the increased savings rate by consumers may also be playing a role in the bond market rally, especially as it appears that smaller investors are becoming more risk averse and are moving funds out of stock mutual funds and into the bond market.

Given recent talk by some Fed governors that the Federal Reserve may need to expand its bond repurchase program if the economy continues to slow and the text from the recent FOMC meeting declaring that interest rates will remain at low levels for some time to come, it appears that the Fed is sending signals that it will do what it takes to keep interest rates low until we see real growth in the economy, which in turn supports even higher bond prices. A look at the most recent Commitment of Traders (COT) report may surprise many analysts, as only non-reportable traders (small speculators) are net long 30-year bond futures, while both non-commercial (large commodity and hedge funds) and commercial (hedgers) are net short the long end of the curve. Large speculative accounts are normally known as trend followers, so being short the rising bond futures market seems unusual. However, this group is net long the ten-year note futures and may represent a spread trade involving the steepness of the yield curve, which is actually supportive of lower yields for Treasuries. Although it seems that Treasury yields will need to rise in the future, particularly given the size of the US deficit, it may be months or even years away, especially if the Fed continues to intervene in the bond market. While picking the exact top in a market is every trader’s dream, sometimes it is better to trade with the trend until both fundamentals and technicals signal an end to the bullish stampede.

Trading Ideas

Given the strong upward trend in 30-year bond futures, some bullish traders may wish to investigate strategies that will benefit from a continued upward move in bond prices. One such trade would be selling puts on bond futures options. A look at the daily continuation chart for bonds shows good support around the 125-00 area. With December bonds trading at 132-19 as of this writing, a trader could sell an October bond 125 put for about 17/64, or $265.62, not including commissions. The premium received would be the maximum potential profit on the trade and would be realized should December bonds be trading above 125-00 at option expiration in September. Given the risks involved in selling naked options, traders should have an exit strategy in place should the position move against them. One such strategy would be buying back the short put should the option premium trade at three times the amount received for originally selling the option.

Technicals

Looking at the daily continuation chart for 30-year bond futures, we notice that despite the strong rally we have experienced during the past several weeks, prices are still well below the all-time highs seen back in early 2009. Back then, bond prices moved “parabolic” before a top was in place. In the current move, the rally has been more orderly, which is encouraging for a sustained move. With the 200-day moving average currently near the 121-00 level, even a significant correction would not negate the market’s bullish bias. The next resistance level is seen near 138-00, with support found at 125-00.

By Mike Zarembski, Senior Commodity Analyst, OptionsXpress.com

Related Articles on STRATEGIES