It's always interesting to see how (or if) the quantitative aspect of options trading matches up with the qualitative stories in the market.
While we definitely prefer to use quantifiable data to help with decision-making here at tastytrade, qualitative information can often provide additional context and insight.
In the midst of the first quarter of trading in 2019, it’s becoming more clear that remarks made by the Chairman of the US Federal Reserve late last year have almost certainly played a big role in the equity rebound observed in recent weeks (along with optimism over the US-China trade war “truce”).
On January 4th, which (coincidentally?) was only days after some huge down moves in international equity markets, Fed Chairman Jerome Powell communicated to the world a much more dovish stance on interest rate policy. The remarks appeared to walk-back the more hawkish tone he had taken only weeks earlier, when announcing another hike in short-term rates.
On the day of Chairman Powell’s remarks (January 4th, 2018), the S&P 500 rose 3.4%, and has hardly looked back since.
Price movement in interest rate-related financial products has emphasized the importance of that day.
As we know, interest rates and bond prices tend to share a strong inverse correlation. And the TLT, which is basically a proxy for long-term bond prices (20-year+), has responded favorably to Chairman Powell’s new stance. With the threat of higher rates now reduced, the TLT bounced out of a downward pattern, and has traded sideways (but with support) ever since.
Given the above information, it probably won’t surprise you to hear that the implied volatility “balloon” in Treasuries has also deflated considerably. This breakdown in implied volatility caught the attention of the Options Jive team, and is one reason Treasury volatility was the focus in a new episode.
With the Federal Reserve touching the breaks in interest rates, the risk of a big move in the near-to-middle term has seemingly been reduced - at least according to implied volatility in products like the /ZN (10-year Treasury), as shown below:
As you can see in the slide above, implied volatility as of early March in /ZN was sitting around 3.6, which is close to the lowest levels observed since 2010.
However, deciding whether low levels of implied volatility are “cheap” is another matter completely - and highly dependent on your own strategic outlook, trading style, and risk profile.
In order to shed more light on that question, the Options Jive team took a closer look at /ZN and its recent movement. Through that analysis, the team found that the move implied by the option prices in /ZN was +/-1. Looking back on the last year of historical trading data in /ZN, the underlying has moved more than 1 only 37% of the time (on a monthly basis).
That means that while implied volatility is low in absolute terms, it does match with the actual historical movement observed in /ZN recently. In that regard, one might view this volatility as “cheap” only if you expected a material change in the behavior of Treasury price movement, or if you planned to use low levels of implied volatility in Treasuries as as hedge against selling higher levels of implied volatility in another security/product.
For example, TLT has been historically negatively correlated to SPY, as discussed in a previous blog post. In that sense, SPY and TLT may allow for portfolio diversification, because putting on the same position in each wouldn’t likely result in the same outcome. For traders of short index volatility such as SPY or other non-correlated assets, this may provide the basis for taking a closer look at Treasury volatility.
To learn more about the current market landscape in Treasuries, we recommend reviewing the complete episode of Options Jive when your schedule allows. Additionally, this installment of Market Measures covers the historical relationship between SPY and TLT.
If you have any questions about the material discussed in this post, we hope you’ll reach out by leaving a message in the space below, or by sending us an email at firstname.lastname@example.org.
We look forward to hearing from you!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.