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Bond ETFs, Calendar Calls and the Business Cycle

With the U.S. Federal Reserve recently taking a pause in increasing short-term interest rates, a stock options strategy to consider for a future date is calendar calls spread stock options with positions in bond fund ETFs. We will consider longer-term bond fund ETFs, in particular we will consider the iShares 20+ Year Treasury Bond Fund (TLT).

Implementation of this strategy assumes long-term interest rate yields are decreasing. The optimal time to implement this strategy would be during a business cycle with a softening economy and the Federal Reserve loosening the money supply. It should be noted the TLT bond fund ETF is based on long term bond prices which the Federal Reserve does not have direct control, but we will make the assumption that if short term interest rates which the Federal Reserve does have control are decreasing then long term interest rates should decrease as well.

Since long-term interest rates have been declining recently, we decided to back test this strategy using PowerOptions new SmartHistoryXL Back Testing tool searching for positions on July 24, 2006 with all short-term options expiring on August 18, 2006 (August options expiration day). The search parameters for the back test are shown below:

SmartHistoryXL Selection Parameters Greater Than Less Than
Option Volume 0  
Prev Option Volume 0  
Option Bid Price 0.1  
Delta Ratio 2  
Debt/Strike Diff Ratio   1
Sort Results Table By Delta Ratio  
Near Option Expiration Time Frame August  
Far Option Expiration Time Frame All Months  
Far Option Days to Expiration 120  
Order results High to Low  
Recommended Lists TLT  

The SmartHistoryXL back test returned twenty TLT calendar call spread positions and we selected the position with the highest delta ratio. The result of the back test for the selected position is shown below:

Results for Calendar Call Spread search on July 24, 2006
Stock
Sym
Stock
Price
Short
Opt
Strike
& Mo.
Short
Opt
Short
Opt
Bid
Long
Opt
Strike
& Mo.
Long
Opt
Long
Opt
Ask
Stock
Price
8/18/2006
Short
Opt
Ask
Long
Opt
Bid
Net
Value
%
Ret
TLT 85.28 Aug 06 87 TLTHI 0.2 Dec 06 79 TLTLA 6.8 86.77 0 7.8 7.8 18.2

Analysis

For this position, the long-term bond yields decreased during the time period resulting in a price increase of TLT from 85.28 to 86.77 (bond yields and bond prices move inversely). The selected calendar spreads position returned 18.2% in 24 days. We also analyzed this strategy for stock options expiration in May, June and July of 2006 realizing returns of +9.6%, -10.8% and +12.1%, respectively, and even though the current market environment is not exactly conducive for this calendar call spreads, the overall results of this strategy for options expiration in May through August were excellent with an average monthly return of +7.3%. Additionally, for the one losing position, the story may not be over, as the long calls position can potentially be used to write another short call option. So even though the June TLT calendar calls position was down -10.8% in July, successive stock options positions may recover a loss and potentially even be converted to a profit.

PowerOptions provides Internet based tools for analyzing stock options with specific search criteria and for finding potentially lucrative option income. For those seeking to execute a calendar call spread investment strategy for their personal portfolios, PowerOptions provides an Internet based search engine for finding potentially lucrative income producing calendar call spread options positions.

[tags]stock options, option income, calendar spreads, long calls, investment strategy[/tags]

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