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Today


IVolatility Trading Digest™


Volume 16 Issue 46
Considering Interest Rate Hedges [Charts]

Considering Interest Rate Hedges [Charts] - IVolatility Trading Digest™

Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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Review NotesAlthough US Treasury Notes and Bonds are oversold using traditional analytical tools and subject to reversing, it makes sense to start considering alternatives for a long-term hedging strategy, assuming significant policy changes result in rising interest rates. After a brief market review, we compare two hedge alternatives, the first for iShares 20+ Year Treasury Bond (TLT) and then ProShares UltraShort 20+ Year Treasury (TBT).

Review NotesS&P 500 Index (SPX) 2213.35 continued higher gaining another 31.45 points or +1.44% for week, closing well above the previous high at 2193.81 made on August 15, although not actually resistance, which is defined as a former price low, while former highs are benchmarks or target highs, and while not quite the same as resistance they are important. However, once beyond the previous high, the term "without overhead resistance" describes the bullish atmosphere.

VIXCBOE Volatility Index® (VIX) 12.34 declined .51 points or -3.97% for the week confirming the advancing S&P 500 Index. IVolatility’s comparable implied volatility index mean, IVXM declined .81 or -7.51% to 9.98.

VIX Futures Premium

The premium measures the amount the futures currently trade above or below the cash VIX, (contango or backwardation) until front month future converges with the VIX at expiration. Depending on the time to expiration, premiums for normal term structures during uptrends are 10% to 20% and decline when the VIX advances faster than the nearest future as the market declines and/or the futures decline as the front month expiration approaches. Premiums less than 10% suggest caution and negative premiums indicate oversold conditions when the VIX is higher than the futures and are usually associated with reversals.

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Now well within the comfort zone for uptrends, although on low volume the open interest ended the week at 390,646 contracts compared to 402,996 contracts the week before.


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StrategyAlthough, too soon to have a high confidence level about any of the preliminary market moves, some major indexes and sectors appear overbought while others look oversold. Although lacking specifics the markets seem to be expecting less globalization, stimulative fiscal policies, increased US growth, higher inflation, a stronger US dollar, higher interest rates and therefore lower bond prices.

Since it could be many months before any policy changes affect the economy, sector rotation is likely to increase, swinging between overbought and oversold, as more information becomes available. Assuming initial market reactions are correctly signaling the start of new long-term trends, it seems like a good time to review alternative interest rate hedges.

IRatesiShares 20+ Year Treasury Bond (TLT) 120.82 declined .03 points or -.02% for the week, but down 9.27 points or -7.13% since November 8. However, the gap lower decline on November 9 ended the uptrend, USTL that has been in place since December 30, 2013 during the "taper tantrum" shown here.

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With a current yield of 3.02%, the yield at 115, on the USTL, between the current support at 120, S1 above and S2 support at 110 would be 3.25%. At 110, support S2 the yield would be 3.36% and 3.97 back at the December 30, 2013 low of 101.17. With duration of about 21 as interest rates rise to 3.97, TLT should decline from 120 to just about 100, about 20 points lower. However, before then it will likely attempt to recover some of the recent initial decline testing the USTL and perhaps even the gap on the daily chart around 127.

For nimble traders, positioning for an oversold bounce seems reasonable, but any bounce could be weak, since the long-term direction has changed based on the trendline. However, in preparation for a continuing decline, after a possible counter trend bounce, consider the options data and ideas below.

The current Historical Volatility is 15.97 and 9.71 using the Parkinson's range method, with an Implied Volatility Index Mean of 15.90 down from 17.15 the week before. The 52-week high reached 18.47 on February 11, 2016 while the low was 11.21 on December 24, 2015. The volatility chart suggests a return to the mean estimate of 14.

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The implied volatility/historical volatility ratio using the range method is 1.64 so option prices are still relatively high compared to the recent movement of the ETF. Friday’s option volume was 42,131 contracts traded compared to the 5-day average volume of 94,880 with reasonable bid/ask spreads.

Consider this put spread.

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Using the ask price for the buy and mid for the sell the call spread debit would be 1.27, about 32% of the distance between the strike prices with 45% of the long side risk hedged by the short put and with a slight volatility edge.

ProShares UltraShort 20+ Year Treasury (TBT) 40.22 added .06 or +.15 for the week. However, momentum has slowed suggesting increasing probability of a pullback.

The current Historical Volatility is 30.17 and 18.86 using the Parkinson's range method, with an Implied Volatility Index Mean of 30.69 down from 33.86 the week before. The 52-week high reached 36.35 on February 11, 2016 while the low was 21.80 on May 27, 2016. Referring again to the volatility chart, it looks like 27.5% represents a reasonable estimate for a return to the mean.

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The implied volatility/historical volatility ratio using the range method is 1.63 so option prices are relatively high compared to the recent movement of the ETF. Friday’s option volume was just 6,993 contracts traded compared to the 5-day average volume of 9,480 with wide bid/ask spreads.

Here is another spread idea, this time using calls since TBT moves in the same direction as interest rates.

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Using the ask price for the buy and mid for the sell the call spread debit would be 1.39 about 35% of the distance between the strike prices with 34% of the long side risk hedged by the short call and with a slight volatility edge. However, a decline from the current level will confirm slowing momentum so a credit spread could be a viable short term alternative for a counter trend pullback implemented by reversing the Buy and Sell.

While neither position has much implied volatility edge, the TLT has a liquidity advantage with closer bid/ask spreads, an important if there is an oversold bounce, which seems quite likely.

The spread suggestions above are based on the ask price for the buy and middle price for the sell presuming some price improvement is possible. Monday’s option prices will be somewhat different due to the time decay over the weekend and any price change.


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Summary

The initial market moves after the Presidential election seem to be losing momentum, after providing some indications of what to expect after overbought and oversold indexes and sectors correct. In the meanwhile, sector rotation is likely to become even more challenging during a period of policy and political uncertainty.

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Next week will include a more comprehensive market review along with an update for crude oil since last week’s Commitment of Traders Report from the CFTC was delayed by the Thanksgiving holiday and by then the results of the OPEC meeting should be known.

Finding Previous Issues and Our Reader Response Request

All previous issues of the Digest can be found by using the small calendar at the top right of the first page of any Digest Issue. Click on any underlined date to see the selected issue. Another source is the Table of Contents link found in the lower right side of the IVolatility Trading Digest section on the home page of our website.

CommentAs usual, we encourage you to let us know what you think about how we are doing and what you would like to see in future issues. Send us your questions or comments, or if you would like us to look at a specific stock, ETF or futures contract, let us know at Support@IVolatility.com or use the blog response at the bottom of the IVolatility Trading Digest™ page on the IVolatility.com website. To receive the Digest by e-mail let us know at Support@IVolatility.com

 

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IVolatility.com is not a registered investment adviser and does not offer personalized advice specific to the needs and risk profiles of its readers.Nothing contained in this letter constitutes a recommendation to buy or sell any security. Before entering a position check to see how prices compare to those used in the digest, as the prices are likely to change on the next trading day. Our personnel or independent contractors may own positions and/or trade in the securities mentioned. We are not compensated in any way for publishing information about companies in the digest. Make sure to due your fundamental and technical analysis homework along with a realistic evaluation of position size before considering a commitment.

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