How to Trade Treasury Yields With Options

I spend plenty of time talking about U.S. Treasury yields. And there’s a good reason for that…

Treasury yields influence everything from mortgage rates and business loans to the U.S. dollar and stock valuations, as well as broader financial conditions. The Federal Reserve also watches them closely for what they can tell policymakers about inflation, growth, and interest rate expectations.

Right now, the U.S. 10-year Treasury yields are pushing towards 4.75% (an 18-month high). Meanwhile, the 30-year yields are at their highest level since June 2007. So there’s a lot to watch.

As you’d expect, much of the discussion has focused on the danger that rising yields pose for stocks. Higher yields increase borrowing costs and put pressure on highly valued growth companies, such as the mega-tech stocks.

Yet outside of the potential fallout, today I want to show how you can trade these moments for profit…

Why Bonds and Yields Move in Opposite Directions

First, let’s do a quick recap on the relationship between bond prices and yields. The relationship can be confusing because they move in opposite directions.

Say, for example, the U.S. government issued a Treasury bond for $100 that pays 4% interest. The buyer receives $4 a year.

Then interest rates rise. As a result, newly issued bonds might now offer a yield of 5%. Investors can buy a new $100 bond paying $5 a year.

Naturally, investors won’t be willing to pay the same price for the lower-paying 4% bond when newly issued bonds offer a higher return. So its price falls, increasing the effective yield to a new buyer and making it more competitive with prevailing rates.

Note that the reverse applies when interest rates fall. If new bonds are paying 3%, for example, a 4%-paying bond is even more attractive, which pushes its price higher.

This inverse relationship is fundamental to understanding the bond market – and how we go about our trades.

Turning a Yield View Into a Trade

One way you can trade your view on Treasury yields is through a futures account. But there’s another method that’s much more accessible and straightforward. What’s more, it enables us to tightly control our risk.

I use an exchange-traded fund (ETF) – such as the iShares 20 Plus Year Treasury Bond ETF (TLT) – that gives exposure to long-term U.S. Treasury bonds. But rather than trading TLT directly, I trade it using options.

So let’s look at a simple example.

If I think long-term Treasury yields are going to rise, I could buy a put option on TLT, which increases in value when the underlying asset falls. Remember, rising yields mean falling bond prices, which should push TLT lower and increase the value of my put option.

It works the other way too. If I expect yields to fall, I could buy a call option. Falling yields should push Treasury prices (and TLT) higher, increasing the value of our call option.

This strategy also another advantage.

Because I’m buying the option rather than the underlying ETF, my maximum risk is defined from the outset. No matter how far the trade moves against me, the most I can lose is the premium I paid for the option.

That gives me a simple way to trade Treasury yields in either direction while keeping my risk firmly under control.

Happy Trading,

Larry Benedict
Editor, Trading With Larry Benedict