An Income Trade on Treasury Bonds

12/27/2011 9:00 am EST

Focus: TRADING

Carley Garner

Senior Strategist and Broker, DeCarley Trading, LLC

Bond market analyst Carley Garner provides a longer-term outlook for Treasury notes, explaining how traders can sell options on Treasuries to generate premium in the current environment.

We’re talking today with Carley Garner, who has a newsletter called The Bond Bulletin. Give us your long-term perspective on the bond market.

I think if you ask anybody that question, everybody’s going to say they’re bearish Treasuries. They expect interest rates to go up, but I’ll tell you what, I’ve been in this business for seven years and I’ve been hearing that every day for the entire seven years.

Long term, I’d say that probably is the answer, but what is long term?  Is it two years, is it five years, is it ten years? 

Eventually, rates are going to go up. Is it going to be next week or next month? Probably not; not dramatically, anyway. 

Obviously we’re dealing with market conditions that are influenced by central banks, and it doesn’t matter that yields in the 30-year are under 3% and it seems crazy to put your money in 30 years, 3%, but those things don’t matter. People are trading on emotion, and with outside forces, it’s really hard to break the cycle.

Now you just mentioned central bank moves. Some of the central banks around the world—not just in the US—have been making some high-profile moves lately. Give us your perspective on how that could affect the bond market.

It’s interesting because the central banks seem to have more influence over the bond market simply by projecting what they’re planning on doing than actually doing what they’re doing. 

I can tell you the last couple rounds of quantitative easing here in the US anyway, there was all this hype when people started speculating that it was going to occur, and how it was going to occur, and how much, but once they actually got in and started buying up their own Treasuries, the market came off, and it’s more of a “Buy the rumor, sell the fact” kind of cycle. 

Carley, you’ve mentioned that longer-term Treasuries are probably not the best idea for traders right now. What should they be doing?

Well, the way we’ve been playing Treasuries actually is selling options against every large spike in bonds. 

It’s a dangerous game, but because the market’s been in an uptrend for so long, people are kind of entrenched in this idea that you can’t fight the Fed. The call premium is extremely expensive, so every time that the market rallies sharply two or three handles, if you look out, you can sell options ten, 12 handles out of the money for nice premium simply because the trend is your friend.

That’s how option traders think, so there are a lot of people buying out-of-the-money calls, and we’re taking the opposite side of that bet by selling to them. 

So, what should traders be doing to track these developments so they know the right times to get in or out?

Well, really, the thing with option trading is volatility. Bonds are in an uptrend, obviously, and very little has been able to change that.

You don’t sell options in quiet markets, and if you’re a futures trader, you don’t want to sell futures in a quiet market because markets don’t stay quiet forever and that’s how you get in trouble.

If you see a nice large spike that seems irrational, a lot of times it is irrational. Markets, they do that. They make a huge move and then they come back to equilibrium, so that mean-reversion trade sometimes can work very well in Treasuries.

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