Note: Please look for the interview with Jay Kaeppel in the November 2009 issue of Technical Analysis of Stocks and Commodities magazine on newsstands now.

The stock market continues to work its way higher, extending its gains since the March 2009 low. The S&P 500 benchmark index is now roughly 60% above its closing low from March 5th. Interestingly, very few people seem to have had their opinions changed by this massive (by any measure) rally. The bears continue to believe that another economic dip is in the offing and that this is simply a rally in a longer-term bear market.

The bulls believe one of two things:

1. "The stock market is a leading indicator of future economic activity and not vice versa. Therefore, if the stock market is going up while things look somewhat grim, then I will focus on impending good economic news rather than the somewhat grim news of today."
2. "I am a buy-and-hold investor, and need to make a whole lot more just to get back to breakeven, so if the stock market is going up you'd better believe that I believe."

So we have essentially two different routes to the same place.

But of course the stock market is not the only game in town. For example, much attention has been focused on the gold market of late, as the yellow metal recently broke out above the $1,000 level (causing especially great joy among the perma gold bugs - well, at least the ones who haven't already died of old age), so most of the attention is focused on stocks and gold. Therefore, as a good little contrarian, I feel compelled to ask the obvious question, "What about bonds?"

The Bond "Market"

The bond market is not something that most people think about often. And when they do it is typically viewed either as a "portfolio hedge," as "a tool for portfolio diversification" or as "a place to park money now that I've sold my stocks in a panic." In reality, the bond market is not just one market but a variety of markets, for there are key differences among various types of bonds - differences based primarily on just who is issuing the bond in question. To wit, there is the:

• Treasury bond market
• · High grade corporate bond market
• · Junk bond (low grade corporate) market
• · Municipal bond market
• · Convertible bond market

Each bond price fluctuates in price based on at least two factors:

1. The movement of interest rates - rising rates means lower bond prices and vice versa. Also, the longer the amount of time left until a bond matures the more sensitive the price of that bond will be to fluctuations in interest rates.
2. The (real and/or perceived) creditworthiness of the bond issuer.

Treasury bonds are backed by the "full faith and credit" of the United States Federal government (hey, stop that snickering) and therefore (at least until the Chinese "call their loan") fluctuate solely on the basis of interest rate movements. At the other end of the spectrum, the price movements of junk bonds - issued by companies of at least somewhat questionable creditworthiness - actually correlate much more closely to the actions of the stock market than to the action of interest rates, since their fortunes are so closely tied to the performance of the overall economy and the ability of companies to prosper.

Figure 1 displays the recent price action of four different types of bonds. In the upper left is ticker TLT, which represent the long-term Treasury bond. Figure 1, below, shows that it has spent most of the year declining in price as long-term interest rates firmed.

The other three are:

1. Upper right: ticker LQD - representing high grade corporate bonds
2. Lower left: ticker JNK - representing low grade, or junk, bonds
3. Lower right: ticker CWB - a basket of convertible bonds (i.e., bonds that may be converted into shares of stock)

Figure 1 - (clockwise from upper left) Long-Term Treasury Bonds, High-Grade Corporate Bonds, Junk Bonds, Convertible Bonds

As you can see, the other three have spent most of the year rising in price, essentially in step with the stock market. Presumably if the economy improves and if the stock market continues to move higher, these three will perform well. If the economy takes another dip, we can look for these to decline.

For now, let's take another look at the long-term Treasury bond, which fluctuates based solely on the action of interest rates.

Playing the Long Bond

The potential outlook for the long-term Treasury bond can be summarized as follows:

1. If the economy remains weak or experiences a "double dip", interest rates will likely decline and thus long-term bonds would rally in price.
2. If the economy limps along interest rates will likely remain relatively unchanged and long-term bonds will mostly fluctuate within a range.
3. If the economy gains strength, long term rates will almost certainly rise and thus long-term bonds will decline in price.

So it basically comes down to your opinion about the future direction of the economy. With unemployment approaching 10% and with soaring government spending and debt it is not difficult to come up with a bearish scenario for the economy. Still, the stock market - which is a leading indicator for the economy - trends steadily higher.

Figure 2 displays the ticker TLT with one interpretation of the Elliot Wave count overlaid. This count is presently projecting to much higher levels (roughly 129 from a current level of 96.2). The ProfitSource Time & Price Projection - a.k.a. TAPP, which is a separate tool for projecting potential price movements - is also shown (it is projecting a move to at least 105).

Figure 2 - Elliot Wave and TAPP Price Projections for Long Term Treasuries 

Now the first question is, "How much faith can we put into these projections?" And the honest answer from this pundit is, "It beats me." Still, I find the possibility quite intriguing and my first thought is not so much, "Will it happen?" ("it" being a big up move in the price of bonds), but rather, "Is there a way I can make money if it does and not lose a lot of money if it doesn't?"

And I am so glad I asked.

As I have been pointing out in recent weeks, option strategies give investors and traders a great deal of flexibility in terms of being able to craft a position to match a particular desired reward-to-risk scenario. The projected scenario for long-term bonds shown in Figure 3 is a classic case in point. If a trader truly believes that long-term bonds are headed sharply higher, the most straightforward approach would be to pony up $9,620 and buy 100 shares of TLT at $96.20 a share. This transaction would result in the risk curve displayed is Figure 3.

Figure 3 - Risk curve for long 100 shares of TLT

The risk "curve" in Figure 1 is not so much a curve as it is simply a straight line. This is because as TLT goes up a point, the trader makes $100, and as TLT declines a point he loses $100. Like I said, pretty straightforward. But this is by no means the only way to play. The strategy we will look at now is typically referred to as a "call ratio backspread" (just sort of rolls right off the tongue, no?), or "ratio spread," or "backspread" for short.

The trade we will look at involves:

• Selling 4 March 2010 TLT call options at a strike price of 90
• Buying 6 March 2010 TLT call options at a strike price of 95

The risk curves for this trade appear in Figure 4.

Figure 4 - Risk Curves for TLT Call Ratio Backspread (through March expiration)

You will note that the price to enter this trade - and the maximum risk - is $1,539 (rather than $9,620). Please note however that this maximum risk would only be experienced if:

1. The trade is held until March option expiration, AND;
2. TLT closes at exactly 95 on the day of March 2010 option expiration.

So while the cost to enter the trade is $1,539, the actual risk can be far less if this trade is managed properly. For example, if we simply resolve to exit this trade no later than 30 days prior to March 2010 option expiration - i.e., we will exit the trade no later than 2/17/2010 - this gives us four months for bonds to make a move. In addition, we get the risk curves that appear in Figure 5.

Figure 5 - TLT backspread risk curves through 30 days prior to option expiration

In this case we now retain all of the upside potential, but our risk is only $635 (note that this value can fluctuate somewhat based on changes in implied option volatility - i.e., of volatility rises, this risk value shrinks and is volatility falls this risk value may increase somewhat).

So let's consider our best-case scenario:

• If TLT zooms to 130, the long 100 shares position that cost $9,620 will make $3,380.
• If TLT zooms to 130, the 4x6 March backspread that cost $1,539 and in reality risks roughly $650 will make approximately $5,300.

So for a true bull the choice here is:

• Invest $9,620 in hopes of making $3,380 (or 35%);
• Invest $1,539 (and risk roughly $650) in hopes of making $5,300 (or 244%).

Okay, that is all well and good. Still, the odds would seem to be against the likelihood that TLT will really stage a rally of that magnitude. So let's consider some more likely possibilities. Let's assume that TLT will rise or fall no more than a certain amount, and will end up somewhere between $87 and $108 by 2/17/2010. How do these two trades compare then? The "zoomed in" risk curves for our TLT backspread appear in Figure 6.

Figure 6 - "Zooming In" on TLT Call Ratio Backspread Risk Curves

• If TLT rises to 108, the long 100 shares position will make $1180, or 12%.
• If TLT declines to 87, the long 100 shares position will lose $920, or -9.6%.

• If TLT rises to 108, the call backspread will make $1,020, or 66%.
• If TLT declines to 87, the call backspread will make (yes, make) $245, or 16%.

So if TLT rises or falls dramatically between now and 2/17/2010, the call backspread will make more money (at least on a percentage basis and in most cases in dollar terms) than the long 100 shares position.

As with all things in life - and especially with options trading - there is no "free lunch." In this example, if TLT remains exactly unchanged the long 100 shares position will show no profit or loss while the backspread position will lose $650.

So the fundamental question is, "Are you willing to risk $650 in anticipation that long-term bonds will move dramatically between now and February of next year?"

SUMMARY

As always, the example in this piece is an "example" and not a "recommendation." The real point of all of this is to point out that an option trade can afford a trader the opportunity to take advantage of a possible price movement with limited risk (and a relatively low commitment and dollar risk). A trader who is not entirely compelled to think that bonds will advance sharply will unlikely feel compelled to plunk down $9,620 to buy 100 shares of TLT. However, a trader who is willing to assume a reasonable risk - approximately $635 in this example - in an option trade can afford the opportunity to make a significant return.

Remember Jay's Trading Maxim #3,217: There is more to life than buy and hold.

Jay Kaeppel
Staff Writer and Author of Seasonal Stock Market Trends
Optionetics.com ~ Your Options Education Site

NOTES:

Please look for the interview with Jay Kaeppel in the upcoming November 2009 issue of Technical Analysis of Stocks and Commodities magazine.

To learn more about Seasonal Stock Market Trends: The Definitive Guide to Calendar-Based Stock Market Investing, please click here.