With Fed Chairman Jerome Powell hinting at a rate cut next month, bond traders are now focusing on the size of the initial cut and future easing. Powell made his clearest signal yet last Friday, saying the time to lower the benchmark rate from its 20-year high has arrived.
After Powell’s speech, U.S. Treasury prices rose, with yields across all maturities falling. The 10-year Treasury yield ended the day at 3.8%, down 8 basis points from the previous week. Bloomberg’s index shows a 1.44% yield on U.S. government bonds this month.
Treasuries are set for their fourth consecutive month of gains, the longest positive streak in three years. The prospect of Fed rate cuts has lifted the S&P 500 by 18% so far this year. Since late June, the Bloomberg Dollar Index has dropped over 4%.
Rate cuts also present new investment opportunities, like the $iShares 20+ Year Treasury Bond ETF(TLT)$ Swap contract pricing shows traders expect the Fed to cut rates by a total of 100 basis points this year, anticipating rate cuts at all three remaining Fed meetings. This means there’s significant upside potential for Treasuries.
For U.S. Treasuries, consider a calendar spread strategy to capitalize on these movements.
What is a Calendar Spread Strategy?
A calendar spread strategy takes advantage of the differences in time value between options with different expiration dates to profit from time decay. Short-term options lose time value more quickly than long-term options.
By selling a near-term option and buying a longer-term option with the same strike price, you can profit from the net time value difference, since the short-term option decays faster, and the long-term option decays more slowly.
Example of a $iShares 20+ Year Treasury Bond ETF(TLT)$ Calendar Spread
Suppose a trader expects TLT to rebound significantly in the future but anticipates a stable short-term market.
Investors can buy a call option expiring in February 2025 . However, due to the long time before the expiration of the option, the price of the call option will be high. Investors can sell a call option that expires in the near term to offset part of the premium.
Step 1: Buy a call option expiring in February 2025 with a $100 strike price, costing a net premium of $362.
Step 2: Sell a call option expiring on September 27, with the same $100 strike price, earning a premium of $110.
If $iShares 20+ Year Treasury Bond ETF(TLT)$ ’s price doesn’t reach $100 by September 27, the trader keeps the premium from the sold call option. At this point, the trader still holds the long call option expiring in December and has reduced the cost of the $100 long position.
If TLT remains stable, the trader can continue to sell October call options and collect additional premiums. This way, the trader maintains a long position on TLT while earning premium income even if the stock doesn’t rise.
This strategy is useful for entering a short-term neutral position while being bullish long-term. It also limits potential losses compared to just buying a call option, offering lower risk.
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