This morning US equity futures are higher in pre-market trading after getting a boost from better than expected durable goods orders and jobless claims. Yesterday’s Fed meeting was, as expected, a non-event that produced no new headlines. The Fed reiterated that it would continue Operation Twist through year end, buy $40B of mortgage-backed securities each month, and keep rates “exceptionally low” through mid-2015. They also said they see significant downside risks to the economy but that the housing sector is showing signs of improvement and that household spending is advancing a “a bit more quickly” than thought. Equities ended down on the day, but so did treasuries, which is making us wonder if the rally in credit nearing a top? A chart of US credit risk appetite suggests not, but option traders are thinking otherwise. 

One trade that caught our eye in the options market was the sale of 9,075 TLT Nov. 125 calls for $0.70. Implied volatility in these options was smashed from 17% to 15% as traders like this rushed to sell calls on the belief that TLT will not rally higher than 125.70 in the next 22 days. Typically when bonds fall stocks rally, though yesterday was an aberration and indicative of a confused market.

The case for bonds to head lower is simple: as inflation expectations rise, so will expectations of higher interest rates. These expectations will first manifest themselves in long term treasury bonds. Although at the moment inflation is low and the Fed is doing everything it can to keep long term rates low, inevitably Treasury bonds will sell off. The big question is when this will occur. This trade is a bearish bet on treasuries, but will profit if TLT goes down, stays the same, or goes up less than 3.5%. This is a trade for people cautiously bearish on bonds who do not want to get outright short yet but think the top is very near.

Like this trader I prefer to trade bonds via the options market where I can use calls and puts to lock in better than market interest rates without an outright directional bet. However I do not sell naked calls, not matter how much conviction I have in the trade. Though there is a strong long term case for bonds to head lower, in the short term anything could happen, and a continued sell off in equities will likely send TLT through the 125 strike. I would prefer to see this trade hedged by a further out of the money call option and a break through TLT’s 200-day moving average, where is currently sits, could be a signal to begin getting cautiously short bonds.