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Friday, November 9, 2012 - 05:00
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Friday, November 9, 2012 - 05:00
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Friday, November 9, 2012 - 05:00

Earn 5% Income a Month on This Lower-Risk Trade

Friday, November 9, 2012 - 5:00am

Interest rates, as measured by 10-year U.S. Treasury rates and a number of other interest rates, have been declining for more than 30 years. As the chart below shows, interest rates move in trends that last for decades. Eventually, this trend will reverse as all trends do, and while it seems like it should end soon, there really is no way to know.

When interest rates turn higher, ProShares UltraShort 20+ Year Treasury (NYSE: TBT) should also move higher. This leveraged inverse ETF, correspond to twice (200%) the inverse (opposite) of the daily performance of the Barclays Capital 20+ Year U.S. Treasury Index. (There is no long-term chart of 20-year rates available because these bonds were not issued from 1987 to 1993.)

Bond prices fall when interest rates rise, so this ETF gains when bond prices fall. Because it is leveraged, the ETF rebalances every day, so it will not move exactly in line with the long-term trend, but it has moved in the same general direction as interest rates since its inception. TBT is down more than 13% since the beginning of the year, and has fallen almost 30% during the past three years.

Given the strength of the downtrend in interest rates, buying TBT would be very risky. Since inception, this ETF has declined an average of 2.39% per month. Rather than buying TBT while it is declining, it could be more profitable to sell puts against this security.

Selling put options brings in a small amount of current income for traders. The risk in selling puts is that if there is a large decline in the security the put is written against, the put seller will have to buy the security at the strike price.

In the case of TBT, we will want to be buyers when interest rates start rising. Selling puts that expire in about one month that are about 10% below the current price of TBT should allow us to establish a long position near the ultimate low.

Currently, puts with a strike price of $56 expiring in December are trading at about $0.53. Selling this put would create current income of about $55 for each options contract sold. Without margin, this trade would generate a return of about 1% per month, and if repeated each month for the next year, could return 12%. Fully margined, the trade offers potential income of 5% a month, or about 60% a year.

If TBT falls more than 10% a month, the put could require you to purchase the ETF. But after such a large decline in a short amount of time, TBT would be likely to at least deliver a short-term bounce if it is not marking the reversal in interest rates.

Long-term interest rates are at all-time lows and seem likely to turn higher eventually. Another large decline in rates seems very unlikely. This would make this the perfect time to sell puts against TBT given the low risk of a sudden and large rate drop.

Action to Take --> Sell TBT Dec 56 Puts for $0.75 or less (The higher the price moves, the greater the chance the option will be exercised and the risk potential of the trade changes as that happens.). Do not use a stop loss. At expiration, the premium received will represent a 100% profit in five weeks or you will get to own TBT after a steep drop with a strong likelihood of a tradable bounce following an event like that.

This article originally appeared on TradingAuthority.com
Earn 5% Income a Month on This Lower-Risk Trade

Amber Hestla does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.