Friday, August 20, 2010

Thinking of buying Put options on TLT

Put option is basically an investment that increases in value as the underlying security decrease in price. If the underlying security increases in price or stays constant your worst case loss is the money you paid to buy the option.

Each option has an exercise price and exercise date. European style put options can only be liquidated based on the price on the date of expiry of the option.American put options can be traded all the time.Because of the exercise date there is a decay in value of the option as the exercise date comes closer.Hence with an option,unlike stock, you not only have to be right about the stock price but also the timing when the stock reaches such price.

Recently Seth Klarman gave a speech that can be read here
http://valuestockplus.net/2010/05/20/seth-klarman-notes-from-cfa-institute-speech/

Klarman is seeking an inexpensive hedge against dollar destruction as he is trying to protect against catastrophic tail risk. His way to hedge against inflation is through way out of the money puts on bonds. If interest rates go to double-digit ranges, he will make a lot of money. As long as the insurance is cheap enough, he will do it.
To hedge against inflation I have been thinking of buying out of the money PUT options on TLT(20+ year treasury bond).
http://www.google.com/finance?q=tlt

Shorting this bond means I am expecting inflation and long term interest rates to go up. To keep the risk of time decay to minimum possible I am thinking of buying the longest dated option available.....which currently is Jan 20,2012.

As of today(August 20th,2010) a Put Option with exercise price of $80 is available for $2.6. As each option contract comes in multiples of 100 the minimum money you have to lay out to buy such an option would be 1*2.6*100 = 260$. Here is how the returns will play out based on the interest rate movements
TLT Price vs Long Term Interest Rate


                        
Return in % vs Long Term Interest Rates

Hence this is a high risk high return bet. So I would put a small % of my portfolio in this position. But the advantage of this strategy is that if your bet does not materialize the downside is basically what you paid for the option but the upside is tremendous.

Another very important thing to keep in mind is that lot of people have made this trade since 2008 and none of their dire predictions have worked out.Timing is extremely important in this trade.Who knows 2 years from now this option might expire worthless with LTI rates still at sub 3%.

4 comments:

  1. * If the investment pays off then you are looking at a return of 1*(106-80)*100=2600? But you can loose 1*2.6*100=260 if it does not. Correct?
    * I think you mentioned this earlier, TBT is also a good option. But the risk is higher. They short TLT and pay you twice that. Call options on this one makes the same sense?
    * In the long run the interest rates are headed higher. But 2012 is not too far out. Wish we could buy options further down.
    * I think there is some risk of double dip recession. In that case a put on TLT is useless as the interest rate will not go up at all. I would say that you should also make another bet which takes this into account.

    You are working late night. Keep up the good work.

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  2. In case of PUTS its not simple. So let me separate the option value from the time value.

    Based purely on option value an option struck at 80 at a price of 2.5 would be worth nothing until the TLT goes below (80-2.5) = 77.5.

    Any TLT index value below 77.5 would give a return of (77.5-TLT value)*100 per option contract.

    But till TLT reaches below 77.5 its value will be based on the time remaining for the contract to expire and expected inflation.

    You are right...2012 is not very far out but don't have much choice now besides opening a futures trading account.

    The double dip recession should be hedged independently by buying PUTS on S&P 500.

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  3. Hmmm. Makes sense. Let me know if you place your order for puts.

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  4. Nice article.

    I was wondering, how do you get the pricing on the puts?

    And it shouldn't be too hard to open a futures trading account, right?

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