To The Moon

Starting a Rate-Cut Cycle: Strategies for a Steady Long Position in U.S. Treasuries

Despite a strong economy, bond investors are steering clear of long-term Treasuries as the Federal Reserve begins cutting interest rates.

In the traditional stock and bond markets, recent performance has been lackluster compared to the more attractive returns in cryptocurrencies like Bitcoin. For instance, the Dow Jones has posted seven consecutive losing sessions, and U.S. Treasuries experienced a five-day losing streak last week.

The 10-year U.S. Treasury yield rose sharply for five consecutive days last week, cooling off some of the post-election stock market rally. Yields surged by 24 basis points—the largest weekly gain this year—without discouraging speculative activity.

The poor performance in traditional markets is partially attributed to Wall Street holding off on major bets ahead of the Federal Reserve’s monetary policy meeting this week. The consensus expects another 25 basis point rate cut, but the updated dot plot may signal fewer rate cuts next year compared to initial expectations.

However, with the rise in Treasury yields, ETFs like TLT (iShares 20+ Year Treasury Bond ETF) may have reached a bottom range. What is the best options strategy to go long on TLT? The answer lies in the Diagonal Spread Strategy.

What is a Diagonal Spread?

A diagonal spread involves using options with different strike prices and different expiration dates. Typically, the long leg (buying) has a longer expiration than the short leg (selling). Diagonal spreads include bullish diagonal spreads and bearish diagonal spreads.

A bullish diagonal spread (diagonal bull spread) is similar to a bull call spread but offers enhanced flexibility. The key difference is that the two options have different expiration dates. The trader buys a longer-term call option with a lower strike price while selling a shorter-term call option with a higher strike price, keeping the number of contracts identical for both legs.

Example of a $iShares 20+ Year Treasury Bond ETF(TLT)$ Diagonal Spread

Suppose an investor is bullish on TLT for the next year. They could buy a call option with a $100 strike price expiring on June 30, 2025, as the long leg. Based on the latest trading price, this would cost $128.

After establishing the long leg, the investor can sell shorter-term call options on a monthly basis to create the short leg. For example, they could sell a call option with a $94 strike price expiring on January 17, earning a premium of $38.

Profit Potential

• If the sold call option is not exercised, the investor earns $18 in profit after accounting for adjustments.

• This represents approximately a 30% return relative to the $128 cost of the long leg.

• As the long leg has a much longer expiration, the investor can repeat this process multiple times. Each successful short-leg sale reduces the effective cost of the long call, potentially making it free or even profitable.

Advantages of Diagonal Spreads

Compared to simply buying calls, diagonal spreads offer the additional benefit of premium income, reducing the net premium paid and shifting the breakeven point lower, which improves win rates.

Moreover, the flexibility to choose different strike prices and durations for the short leg allows investors to control risk more effectively.

In essence, a diagonal spread is a low-cost bullish options strategy that is worth exploring for investors aiming to go long on TLT.

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