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Any creative options strategies to hedge for rising interest rates?


RedLion
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I'm looking to purchase a home probably sometime in the middle of next year, I'm concerned about rising interest rates, and would like to come up with a way to hedge against rates rising in the next 12 months. 

 

Has anyone thought about this? 

 

PUTS on TLT, or maybe some type of leveraged preferred stock ETF? I'm probably looking to borrow around $600k, so would love to hedge interest rates for around that dollar amount, I've never traded in futures or interest rate swaps or anything like that, not even sure if they are available for what I'm trying to do. 

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OTM AAL leap puts 

 

edit: its more of a 12-24 month hedge idea. But it should all unfold together. Mountain of debt coming due in 2025. Biggest inputs are labor and oil...both will be the reasons rates would rise. CEO basically levered up buying back stock in 40/50s a few years ago. Bad business to begin with. Lotta ways to win.

Edited by Gregmal
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54 minutes ago, Gregmal said:

OTM AAL leap puts 

 

edit: its more of a 12-24 month hedge idea. But it should all unfold together. Mountain of debt coming due in 2025. Biggest inputs are labor and oil...both will be the reasons rates would rise. CEO basically levered up buying back stock in 40/50s a few years ago. Bad business to begin with. Lotta ways to win.

 

Brilliant. I'm going to have to digest this one, but this seems like it could totally fit my needs. 

 

I've been sitting here researching options on treasury futures, which seems like it might be a decent pure play way to buy puts on a large notional dollar amount without paying through the nose. It still looks like it would cost $18k or so to hedge against $600k  treasury bonds at the money until June 2022, possibly quite a bit cheaper if I lowered my strike prices. 

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1 hour ago, RedLion said:

 

Brilliant. I'm going to have to digest this one, but this seems like it could totally fit my needs. 

 

I've been sitting here researching options on treasury futures, which seems like it might be a decent pure play way to buy puts on a large notional dollar amount without paying through the nose. It still looks like it would cost $18k or so to hedge against $600k  treasury bonds at the money until June 2022, possibly quite a bit cheaper if I lowered my strike prices. 

Well, it may be a good bet, but it’s not a bet on rising interest rates. The bet could work or fail with raising or falling interest rates.I think it is more a bet on crude prices, capital markets (credit spreads) and supply and demand of air travel.

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It will become a vortex of pain and ultimately a death spiral if rates rise. Air travel won’t even matter. Look at all the money they made this last decade and look why they have to show for it and look at the equity value vs the debt. 

1) rates rise a lot, is it easier or harder to refi all that debt? How about more expensive? Market is forward looking and will crush the equity unless debt is rapidly paid down.

 

2) why would rates rise? Well, for starters, inflation. What’s some of the measures for inflation? rising energy prices and labor issues. Boom and boom. AAL also doesn’t hedge. I’d also point out that to meet increased demand for air travel they’ll have to pay more and hire way more. Which will have to be offset by higher prices which could stem demand.

 

3) you could also arguably make the case that these are currently priced optimistically given the recovery trade theme and subsequent expectations of massive future demand. 
 

So if rates rise, it’s because basically everything that wrecks AAL is happening. 

 

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My equity portfolio is 100% invested long, and concentrated. I certainly feel like I could use some asymmetrical put protection, although my history in this regard has been terrible. Most of my net worth is tied up in two closely held businesses where I own 50% stakes, so I've grown to accept more than average volatility in my equities portfolio. 

 

I've had several puts expire worthless over the last 3 years. 

 

My worst mishap ever though was loading up on a bunch cheap BAM puts at a strike price of $55 (pre split) back at the end of 2019 to expire I believe in June of 2020. I sold them for a loss at the end of January 2020, and then proceeded to see my BAM shares drop ~50%. Since I had more puts than shares of BAM I would have actually profited handsomely from the drop if I had just held on to that one position until expiration. I've searched BAM/KKR/APO puts pretty closely, and they're a lot more expensive than before, so I've remained unhedged as I remain bullish about these positions (and they're also my top three in that order). 

 

 

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I would keep it simple. 
 

conventional mortgages may amortize over 30 years, but MBS are far closer in duration to the 10y note than the 30y bond.

 

therefore I’d hedge with the 10 year, futures trade in $100k increments and there are futures options as well if you wish to cap your downside. 
 

far simpler and more direct and a true hedge. Gregmal’s may be a fine investment idea, but has little to do with your desired hedge.

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4 minutes ago, thepupil said:

I would keep it simple. 
 

conventional mortgages may amortize over 30 years, but MBS are far closer in duration to the 10y note than the 30y bond.

 

therefore I’d hedge with the 10 year, futures trade in $100k increments and there are futures options as well if you wish to cap your downside. 
 

far simpler and more direct and a true hedge. Gregmal’s may be a fine investment idea, but has little to do with your desired hedge.

 

I'm trying to wrap my head around this. I'm thinking I would need to open an IB account to put these trades on, but just to make sure I understand what's going on. Do you have a recommendation on where to do research on these trades?

 

I'm looking at this website for quotes on the June 22 futures contracts for 10 year notes. https://www.barchart.com/futures/quotes/ZNM22/overview So essentially I would be looking to purchase a put option on this futures contract. https://www.barchart.com/futures/quotes/ZNM22/options/jun-22 is what I'm looking at for quotes for options on this futures contract, if I'm reading this right then the strike price $129.50 PUT would be at the money, and would cost me $1,516 per $100,000 contract.

 

So for position sizing, you would look to buy 6 put options on 10 year note futures at the money, so approximately $9,000 cost to hedge $600,000 10 year treasury futures at the money until June 2022? 

 

 

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In either event though you need to define and then come to terms with what you looking to accomplish. If it s a hedge, you arent looking to make money. If its kind of a hedge but also kind of a trade, then thats different too. If it is a straight trade, then thats probably the only scenario where you would fully expect to make money on the trade and you really have to make sure all your ducks are in a row. I say this because it took me a while and a good amount of burnt money to realize this. You can put on trades that look good but have poor odds of working; happens all the time and theres no better example than the classic valuation short. I've generally over the years stopped trading on the short side with the sole purpose of making money. I sometimes outright hedge, but its less frequent.

 

My 2020 P&L, specifically on the L side has some real funny looking stuff. Shorts that went against me 50-100% in a quarter or two. Options that were total losses. But in the context of what they were in place for, they worked, because it let the long side do its thing. Only thing that matters is how the aggregate end total looked, and in that instance, I was quite happy.  Where I've been at in 2021 is very similar to the trade @rkbabangmentioned on TSLA. Will it make money? Probably not. Is it even about TSLA? Not really. If shit blows up does it work? Oh hell yea. If shit doesnt blow up is there a chance it still works...maybe, maybe not. But it covers your ass with some high octane fuel. 

 

Tickers are really just an opportunity set and even within the tickers there are opportunities within each individual option chain. All of it is just a means to an end...so define what your end is. On the AAL hedge trade for instance, I am still putting it on, but the idea is that I am getting 2+ years worth of protection and with about 5% risked in the form of options thats a negligible annualized drag. But the payouts could be anywhere from 3:1 all the way up to 10:1 or more. If rates rise it will almost certainly work. And if rates dont rise, it could still also work. If the market keeps going up, its probably not going to work. If the market tanks it will work. Different avenues, but multiple avenues to win. But you also have to be OK with losing. Because if you're doing it right, in the aggregate, when you lose on these trades, you are winning on the other stuff which more than offsets itself. Much different than when you just go long something. 

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On 10/29/2021 at 4:18 PM, RedLion said:

I'm looking to purchase a home probably sometime in the middle of next year, I'm concerned about rising interest rates, and would like to come up with a way to hedge against rates rising in the next 12 months. 

 

Has anyone thought about this? 

 

PUTS on TLT, or maybe some type of leveraged preferred stock ETF? I'm probably looking to borrow around $600k, so would love to hedge interest rates for around that dollar amount, I've never traded in futures or interest rate swaps or anything like that, not even sure if they are available for what I'm trying to do. 

 

You may want to look into PFIX. Some explanation here: https://www.convexitymaven.com/wp-content/uploads/2021/06/convexity-maven-fire-insurance.pdf

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16 hours ago, IceCreamMan said:

 

I've got kids around for halloween today, I'm going to need to make a few pots of coffee and devote some time to poring through this link, because a cursory read is WAY over my head. Very interesting though, and if the author's projections/modeling is correct, it seems like it could be a very good interest rate hedge. 

 

Are swaptions even available to retail investors?

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I would strongly recommend against some options strategy on a fixed income ETF, largely because there are fairly simple instruments you can use to directly hedge interest rate exposure without resorting to some complicated option play where it is unclear what the exact relationship between rates and the payoff will be.

 

Probably the easiest hedge to implement is to sell Eurodollar futures (the Canadian equivalent is BAX futures). The price of a Eurodollar future declines 1 cent for every 1 basis point increase in the expected 3m interest rate at some date in the future. For example if you sold Dec 2025 Eurodollar futures you are protecting yourself for a higher overnight interest rate in December 2025 (https://www.cmegroup.com/markets/interest-rates/stirs/eurodollar.quotes.html).

 

In terms of other ways to hedge rates, you could always look at buying bank stocks or low priced Canadian rate-reset preferred shares. Both should probably benefit as rates rise.

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5 hours ago, RedLion said:

 

I've got kids around for halloween today, I'm going to need to make a few pots of coffee and devote some time to poring through this link, because a cursory read is WAY over my head. Very interesting though, and if the author's projections/modeling is correct, it seems like it could be a very good interest rate hedge. 

 

Are swaptions even available to retail investors?

 

An introduction to PFIX is here:

https://www.convexitymaven.com/wp-content/uploads/2021/05/Convexity_Maven_-_The_Helicopter_Defense.pdf

 

Quote

This Strategy will be constructed with only two assets, each initially about 50%:

 

A seven-year (May 2028) expiration interest rate (put) option on roughly a $1000 twenty-year bond with a strike of 4.25%. This type of option has typically ONLY been available to professionals (with an ISDA contract).

 

A portfolio of US Treasuries with roughly a seven-year maturity.

 

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12 hours ago, maplevalue said:

I would strongly recommend against some options strategy on a fixed income ETF, largely because there are fairly simple instruments you can use to directly hedge interest rate exposure without resorting to some complicated option play where it is unclear what the exact relationship between rates and the payoff will be.

 

Probably the easiest hedge to implement is to sell Eurodollar futures (the Canadian equivalent is BAX futures). The price of a Eurodollar future declines 1 cent for every 1 basis point increase in the expected 3m interest rate at some date in the future. For example if you sold Dec 2025 Eurodollar futures you are protecting yourself for a higher overnight interest rate in December 2025 (https://www.cmegroup.com/markets/interest-rates/stirs/eurodollar.quotes.html).

 

In terms of other ways to hedge rates, you could always look at buying bank stocks or low priced Canadian rate-reset preferred shares. Both should probably benefit as rates rise.


 

This is not the right part of the curve for hedging a (standard US 30 year) mortgage.

 

 

if he intends to take out an ARM, I agree, but don’t think that’s the intent. 

 

why hedge a rise in the mortgage rate, which is 10y tsy + swap spread + mortgage basis with an instrument linked to <1yr rates?
 

 

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1 hour ago, thepupil said:


 

This is not the right part of the curve for hedging a (standard US 30 year) mortgage.

 

 

if he intends to take out an ARM, I agree, but don’t think that’s the intent. 

 

why hedge a rise in the mortgage rate, which is 10y tsy + swap spread + mortgage basis with an instrument linked to <1yr rates?
 

 

 

My suggestion was something that is simple, easy to understand, and the poster could just 'set it and forget it'. Hedging the exposure more closely, but more complex, is to sell US 30yr treasury bond futures; added complication is figuring out what the right hedge ratio is and having to roll the contracts every so often.

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On 10/30/2021 at 1:53 PM, RedLion said:

 

I'm trying to wrap my head around this. I'm thinking I would need to open an IB account to put these trades on, but just to make sure I understand what's going on. Do you have a recommendation on where to do research on these trades?

 

I'm looking at this website for quotes on the June 22 futures contracts for 10 year notes. https://www.barchart.com/futures/quotes/ZNM22/overview So essentially I would be looking to purchase a put option on this futures contract. https://www.barchart.com/futures/quotes/ZNM22/options/jun-22 is what I'm looking at for quotes for options on this futures contract, if I'm reading this right then the strike price $129.50 PUT would be at the money, and would cost me $1,516 per $100,000 contract.

 

So for position sizing, you would look to buy 6 put options on 10 year note futures at the money, so approximately $9,000 cost to hedge $600,000 10 year treasury futures at the money until June 2022? 

 

 

 

More or less, yes. Though, I think you'd probably be overhedging by going at the money and therefore hedging any move in the 10 year note. Perhaps you only want to hedge for a given X%, that would decrease cost. 

 

My logic is this. The mortgage rate is a combination of a number of things.

 

Mortgage rates are determined by

 

Fannie/Freddie's guarantee fee (Constant)

Servicing Fee (constant) 

Rates along the part of the curve where MBS lie (roughly 10 years) 

the mortgage basis (or the difference in expected/modeled yield b/w the tsy/swap rate and mortgages). 

differences b/w various banks (ie if a banks backlog is overwhelmed, they'll increase rates to slow down demand)

 

The most straightforward and largest component of this is the treasury rate at the part of the curve where 30 yr MBS lie, hence my recomendation of 10y futures. You could either short roughly your notional in 10y futures. Or could cap your downside w/ futures options. It depends on what you're trying to solve. If you only want protection from a huge move, I'd buy some further out of the money. 

 

for fun, I just tried to buy a few hundred dollars of 10% OTM options on the June 2022 future which expire in April. They show up as costing pretty much nothing. I'm trying to see if i can get a fill to make sure this is actionable

Edited by thepupil
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31 minutes ago, thepupil said:

 

for fun, I just tried to buy a few hundred dollars of 10% OTM options on the June 2022 future which expire in April. They show up as costing pretty much nothing. I'm trying to see if i can get a fill to make sure this is actionable

 

To follow up, I bought 6 of the January 21, 2022 expiry $115 puts on the March 2022 future. The market value of these is immediately marked down to $80, from the $200 I paid for them. This gives me the right but not obligation to sell 6 of the MArch 2022 10 year note futures, expiring in January. If the 10 year note were to declinne by 20% (a highly highly highly improbably scenario involving several hundred bps of movement over a short time frame, this would be worth $11K from a cost of $200. In the other 99.9% of outcomes, I will lose my $200 bucks and not tell my wife I wasted a nice dinner on an experimental futures options trade. 

 

it seems the shorter expiries have all the liquidity, so you may want to set aside whatever you're willing to lose and roll twice or thrice.

 

In my view this is the most direct way to hedge a rise in rates that are most relevant in determining 30 year mortgages. 

 

Many bothan spies  dollars died in bringing us this information. 

 

As a further wrinkle, I've discovered that the "10 year future" actually is a 6.5-10 year future and one may want to go to the "ultra 10 year note future" for a true 9.5-10.0 year note type of exposure. good times.

Edited by thepupil
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thepupil, are you using interactive brokers to trade the options futures? 

 

Right now I'm at Schwab and I don't believe I have this available. I've been thinking of switching to IB anyway to get paid for lending out shares and have substantially lower margin interest if I end up wanting to use margin more aggressively than I have historically. 

 

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So what I think is more likely than a significant increase in the interest rate on the 10 year, is a possible 1-1.5% increase between now and June 2022. 

 

 

I've never traded a futures option, but I'm wondering if you could place a put spread position on where you buy an ATM put and sell an OTM put to try to get the most out of a potential increase from around 1.5% to 3%. 

 

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5 minutes ago, RedLion said:

thepupil, are you using interactive brokers to trade the options futures? YES

 

Right now I'm at Schwab and I don't believe I have this available. I've been thinking of switching to IB anyway to get paid for lending out shares and have substantially lower margin interest if I end up wanting to use margin more aggressively than I have historically. 

 

 

 

 

Quote

I've never traded a futures option, nor have I until this morning! And if I was doing this for anything other than a demonstration/experiment, I would have put more time/effort into it. You are welcome to research it further to make sure you fully understand. 

but I'm wondering if you could place a put spread position on where you buy an ATM put and sell an OTM put to try to get the most out of a potential increase from around 1.5% to 3%.  interactive brokers shows you an area of options and has a "strategy builder" function for options spreads. If i were you I'd just buy a put to hedge a big move, maybe not so far OTM as the one i bought (which cost 1/64th of a point), but you dont have to hedge the small move, just my 2 cents.

 

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