Hedging Treasury Risk –

If you’re stubborn about holding Treasuries with the pending rate hike and you or your manager doesn’t hedge downside risk you’ll have no one to blame but yourself.

Using an option collar provides protection by selling a call option against your position and using the collected premium to purchase a put option to define downside risk.

1) Benefits

Risk is defined on the trade and for the duration of the trading period

Loses will be limited when the Fed finally engages with rate hikes

If the market stays the same you’ve collected approximately as much time premium as you’ve purchased

2) How it works, start by checking the chart

Click here for a current chart

3) Check your ranges

To determine realistic risk reward levels consistent with the duration of the trade. In this example I’m trading the September 10 Year which goes off the board 21, August 2015 or 18 days from the 3 August 2015 entry.

Click here for current ranges

4) Establish your position.

Long the September T-Note at 127 26/32

Sell the 128 32/64^th call against the long position collecting $335.94

Using the collected premium buy the 126 32/64^th put paying $298.06

5) To experiment with any potential outcome for this trade

Click here to open the corresponding risk/reward spreadsheet, enable it, enter any price into cell C-2

6) Worst case scenario

Rates skyrocket, Treasuries sell off hard to 110 0/32nds for a loss in contract value of -17,812.50 or – 13.93% but because we’re hedged our loss was limited to -$1,266

7) To confirm

A) Enter 110 0/32 in cell C-2
B) Net loss shows in cell E-2
C) Net liquidating value shows in cell E-3

8) The market stays the same you’ve collected your credit premium of $47 plus your interest income.

A) Enter 127 26/32nds in cell C-2
B) Net loss shows in cell E-2
C) Net liquidating value shows in cell E-3

9) Rates move lower, Treasuries rally, the position is called away at a $734 profit plus your interest income and we can reestablish the position immediately.

A) Enter 2,000 in cell C-2
B) Net loss shows in cell E-2
C) Net liquidating value shows in cell E-3

For more advance traders we can write a put below the market for reentry where the only way we could be delivered a position is at a better price,  if the market never goes down to the strike we keep the premium.

Example the 127 put is nearly a full point below the market with a time decay of 0.06% per month or 7.24% annually (far more than the interest income)

If delivered a position you can collar it explained above

Or

You can write a call above the market for example 128 16/32 collecting 0.07% per month or 8.5% annually ,the only way the position can be called away from you is at a profit 0.54% or you were paid 0.7% for that month to sell it at a profit (in at 127 26/32nds out at 128 12/32nds).

Using this strategy the worst thing that will happen to you is you would own a bond that you would have bought or already owned anyway.

Contact me for more information on yield enhancement

These strategies can be traded in any liquid market, crude oil and grains have the highest premium currently relative to contract value.

Regards,
Peter Knight Advisor

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