Hedging TLT

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A Bearish Consensus Growing On Bonds

In a post on Monday (“Hedging to a Hundred“), Tim predicted a ~15% drop for the iShares Barclays 20 year+ Treasury Bond ETF (TLT). There seems to be a bearish consensus growing on bonds in general. Also on Monday, in an interview on Bloomberg TV, GAMCO Investors portfolio manager Larry Haverty offered this warning for bond investors:

We
have a bond bubble… And the public, I am totally convinced, does not
understand it’s going to be possible to lose money in bonds

Haverty
didn’t make as precise a prediction as Tim, but it’s interesting to see technical and fundamental views align here, as Haverty becomes the latest prognosticator to warn about bond bubble.



Downside Protection For TLT Iongs

For
TLT investors staying long despite these warnings, but considering adding downside protection, here are two ways
to hedge the ETF against greater-than-10% drops from its current price
over the next several months.

The first way uses optimal puts*;
this way has a cost, but allows uncapped upside. These are the
optimal puts, as of Monday’s close, for an investor looking to hedge
1,000 shares of TLT against a greater-than-10% drop between now and June
21:


10 TLT Put

As you can see in the screen capture above, the cost of those optimal puts, as a percentage of position, is 0.95%. A note about this cost: to be conservative, this cost was calculated using the ask price of the optimal puts; in practice, an investor can often purchase puts at a lower price, some price between the bid and ask.

A
TLT investor interested in hedging against the same, greater-than-10%
decline over the same time frame, but also willing to cap his potential
upside at 10% between now and June 21, could use the optimal collar
below to hedge.

10 10 TLT Optimal Collar

As
you can see at the bottom of the screen capture above, the net cost of
this optimal collar drops to 0.55%. Unsurprisingly, not as big a drop in net cost from optimal put to optimal collar here as we’ve seen in previous posts, where we looked at hedges on more volatile securities (e.g., tech stocks AAPL and RIMM).

*Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor uses
an algorithm developed by a finance Ph.D to sort through and analyze
all of the available puts for your stocks and ETFs, scanning for the
optimal ones.

**Optimal collars are the ones that will
give you the level of protection you want at the lowest net cost, while
not limiting your potential upside by more than you specify. The
algorithm to scan for optimal collars was developed in conjunction with a
post-doctoral fellow in the financial engineering department at
Princeton University.

The screen captures above come from the latest build of the soon-to-come 2.0 version of the Portfolio Armor iOS app. Optimal collar capability will be available as an in-app subscription in the 2.0 version of the app.