The premium in the market is pretty low right now, and we are just on the tail end of earnings season. We look for stocks that have high volatility (thus, high premium) and don’t have any upcoming earnings.

So when I was looking for a trade to place, I was met with a screen full of low numbers:

Image via dough.com

One of the only stocks that had the qualifications that I was looking for was (Liquidity, High Volatility, No Earnings) was TBT.

TBT is the Double Short Long Bond ETF, and is the inverse of TLT, which is the Single Long Long Bond ETF. (I won’t get into the technicalities of that here)

So if TLT falls by 1%, then TBT will increase by 2%  (approximately).  For comparison, TBT has twice the volume of TLT, smaller bid ask spreads, and 3x the open interest.

TLT tracks the movement of bond prices. So it tends to perform well in an interest-rate stagnant / declining environment (interest rates and bond prices have an inverse relationship), whereas TBT is going to perform better when bond prices fall, which they tend to in a rising interest rate environment.

So when interest rates fall; bond prices increase; TLT does better.

When interest rates increase, bond prices decrease, TBT does better.

The Fed raised interest rates by 25 basis points on March 21, and announced that there would be two more rate hikes throughout 2018. They’ve raised rates 6 times since 2015, bringing it to 1.75%.

A graph of TLT:

Image via Stockcharts.com

A graph of TBT:

Image via Stockcharts.com

The Fed has had a lot of trouble deciding when they should raise rates. If the Fed holds rates too low for too long, that can cause the economy to basically grow too quickly, resulting in a lot of debt, a lot of unnecessary construction, and a lot of over spending. If they raise rates too quickly, then there isn’t enough borrowing, or enough spending.

It’s a slippery slope. A little bit of a catch-22.

But they are on the path to raising rates.

The Fed raised interest rates by 25 basis points on March 21, and announced that there would be two more rate hikes throughout 2018. They’ve raised rates 6 times since 2015, bringing it to 1.75%.

With the new rising interest rate environment TBT is a good place to be. It should, if anything, experience an increase in price as interest rates continue to rise. But overall, nothing drastic should happen to the ETF.

The stock has ranged between $39.68 and $35.36 for the past three months. Since I only plan on holding the trade for 20 – 45 days (I’m placing it at a 52 day expiration), this is pretty good news.

Notice, I just listed quite a few paragraphs listing why this stock would by good to buy. And sure, I could buy the stock, cementing a 50% probability of profit, hoping that the Fed continues to raise rates (likely, but one never knows) and that the stock continues an upward trajectory.

But I don’t have to do that. Instead, I can mechanically define my probability of profit.

I’m going to walk you through two different trades that are “neutral”. This is good to place if you think a stock is going to stay within a price range, and if you get a decent amount of premium for placing the trade.

(Side note: trade for the premium, not for the stock. If you’re getting a decent risk/reward, stay mechanical. This is simple statistics.)

The Trades

The Strangle

This is a neutral trade. It involves selling an OTM put and an OTM call. The goal of this spread is that the stock price will stay within the two strikes.

So for TBT, I sold the 38 put and sold the 41 call. This gave me $124 in credit, a 60% probability of profit, and a pretty good return on capital (0.27%).

I need the stock to stay within $36.76 and $42.24. This comes from my credit of $1.24, and the strikes I put in place. ($38 – $1.24) and ($41 + $1.24)

 

A masterpiece from Paint. 

We will make money if the stock remains within that range. I did a little bit of a “bullish-neutral”, pushing my upside past the 3 month high, just because of the current macro environment.

But this an undefined risk trade. That means when I place the trade, my max loss is unknown. It is undefined because we aren’t buying an option further OTM to hedge that risk, and to offset any potential losses.

But, just buying stock has undefined risk too (fun fact). Theoretically a stock price could go to zero, and you would lose your entire initial investment. Of course, this doesn’t happen often.

But the risk is still there.

With options, we are at least collecting some sort of premium as compensation for the risk. You also don’t have the massive buying power reduction that a stock puts on your account. That’s great news for small accounts like mine.

As Tom Sosnoff, one of the minds behind tastytrade.com, says:

“(Undefined risk), it’s over-commitment and leverage. There is a huge misconception. The industry will tell you the most dangerous thing is undefined risk. Undefined risk is not dangerous at all. What is dangerous is excessive leverage to the point where your position size is too big. Genius doesn’t fail because you use a high statistical probability strategy… Genius fails because you think you know something so you load up on that.”

But sometimes you need to define that risk. Just for peace of mind.

That’s important to do. Sleep is good.

So if you wanted to define your risk on this trade, you would buy a call further OTM, and then buy another put further OTM.

The Iron Condor

Another masterpiece from Paint. 

This is basically a combination short put credit spread and short call credit spread. I am trading the 38/34 put spread and the 41/44 call spread. This combination results in $103 profit and a defined risk of $297.

There is a 56% probability of profit, with a 0.37% return on capital. The deltas are still positive (18.43) because the trade is still skewed bullishly. We want it to stay within a window of $36.97 and $42.03. (38 – 1.03) and (41 + 1.03)

So, there are a couple of different ways that you can trade a neutral spread.

You can play it risky with the Strangle. This will provide you with a little bit more in credit, especially if you place in a high volatility environment, where you can collect more credit on the strikes.

Or you can relax a little with the Iron Condor.

You can play it safe (I am definitely a fan of defined risk) or you can get a little riskier.

Either way, it provides more profitability than stocks. You can define your risk and your reward, and make it so the situation is what YOU need it to be. That’s the beauty, and the power of options.

That it gives you options. (haha)

It doesn’t have to be scary. Sure, trading with your own money isn’t always the most appealing thing in the world. But the profits (and learning experience) that comes from it are well worth it.