Other Voices: Hedging Interest Rate Risk

Options Expert Jay Soloff explains how one big trader is hedging interest rate risk right now

By Jay Soloff

Why are investors so fixated on interest rates? If you follow the financial markets regularly, you’ll notice how laser-focused the investment community is on what the Federal Reserve is doing, how bond markets react, and what it all means for interest rates.

But why are interest rates so important? What does a change of a quarter percentage point mean? As a matter of fact, a quarter-point hike or cut in rates is a lot more meaningful than you may have suspected.

The economy is very much driven by interest rates, which is merely another term for the cost of money. The higher interest rates are the more money costs. Debt and borrowing are a massive part of both our personal lives and the corporate world.

From a business perspective, any move in rates can mean billions in profits or additional costs. It may be evident for a bank, where almost the entire business is related to the interest rate spread. But, it’s also a massive deal for corporations who issue debt.

When businesses can raise money at a lower rate, and use it to create a higher rate of return, they will actively do so. Conversely, a company is less likely to take on debt if it costs too much. That may also mean they are less likely to grow and expand.

From a personal standpoint, we mostly see the impact of rates on mortgages. Lower rates tend to result in more new mortgages and refinancing. Buying homes and doing refinancing tends to result in a significant amount of related economic activity. (A refinance to make home improvements or go on that long-awaited vacation, etc.)

Currently, the futures market (which tracks expected interest rates) gives a 100% chance of a quarter-point rate cut in September. Moreover, futures expect yet another quarter-point cut in October (66% chance). Two cuts in two months is a big deal – so what does the options market think?

When it comes to trading interest rates using ETF options, most of the activity occurs in the iShares 20+ Year Treasury Bond ETF (TLT). Remember, bonds are simply a reflection of expected interest rates. Plus, longer duration bonds are more heavily impacted by rates than short duration bonds.

So, what happened in TLT options?

One trade that caught my eye was a large put purchase in September. More specifically, with TLT trading at $142.51, a trader purchased 1,000 of the September 20th 139 puts for $1.29. The cash outlay was $129,000 for the premiums, which is the max loss on the trade.

Breakeven for the position is at $137.71. Every dollar below breakeven is worth $100 per option to the trader. In this case, it’s $100,000 per dollar lower because 1,000 options were purchased.

So why is this put purchase important? Is it a bet that TLT is going lower (and interest rates aren’t going to keep falling)? Not likely – instead, it’s probably the opposite.

More likely, this put trade (along with several others that I’ve seen in TLT recently) are hedges. It’s far more of a possibility that investors are loading up on bonds because they expect rates to continue to drop. The puts are simply a hedge against a reversal. Given the volatility in the market lately, it certainly makes sense to hedge your positions.

If you are bullish on bonds or own a bunch of bond exposure in your portfolio, TLT is an excellent place to hedge your risk. The put options are not that expensive and give you some protection should interest rates not drop as far or as fast as investors expect.

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