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Has the Love Affair With Treasury Bonds Run Its Course?

A decline in put open interest could pressure the TLT lower

by 11/5/2012 9:26:30 AM
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The following is a reprint of the market commentary from the November edition of the Option Advisor, published on October 25. Prices and the chart are as of the close on October 25. For more information or to subscribe to the Option Advisor, click here.

There is not much more to say about the mechanics of this market -- in which the S&P 500 Index (SPX) ended the month of August at 1,406 and then random-walked its way over the subsequent eight weeks to close today at 1,413 -- that was not stated by Schaeffer's Senior VP of Research Todd Salamone in his Monday Morning Outlook of Oct. 20 entitled "How to Trade a Hot-and-Cold Market."

If by chance you missed Todd's commentary, I strongly suggest you take a look -- if only to focus on an amazing chart of the price action of the S&P MidCap 400 Index (MID) over the past two years and its repeated inability to sustain any rallies above the ultra round-number 1,000 mark since this level was first challenged in April 2011. There were also slight upside penetrations of 1,000 in July 2011, March 2012, and most recently last month, all of which have been beaten back soundly. But perhaps the most important take-away from this chart is that it's not nearly as amazing as it appears, as the uncanny tendency of indices (and share prices) to encounter resistance (or derive support) from round-number price levels has been well documented in our commentaries over the years.

In fact, this principle has been amply illustrated this year in the price action of the most popular stock on the planet -- Apple Inc. (AAPL) -- which just happens to be reporting earnings this evening. This year's high at $705 was part of an extremely brief penetration of the $700 level, and the low so far on the subsequent pullback occurred this afternoon at $605. Whether or not AAPL manages to hold above the round-number $600 mark in the wake of this earnings report will go a long way toward determining its price behavior in the months ahead.

My focus in this commentary is some key price levels in the iShares Barclays 20+ Year Treasury Bond Fund (TLT) that loom as of today's close at $120.86, as I strongly believe the jury is out on the ability of Treasury bonds to retain their huge gains in recent years. A breakdown by TLT below key support levels would be very conducive to a major stock market rally.

iShares Trust Barclays 20 Year Treasury Bond Fund (TLT) Daily Open Interest since December 2010

TLT's rising 40-week moving average sits currently at $121.28, and this key moving average has supported the sharp rally since mid-2011, though it was penetrated slightly over a two-week period in March and there was a sharp -- but very brief -- penetration last month. And just 3 cents below the 40-week moving average -- at $121.25 -- is TLT's closing price on Dec. 30, 2011. This "zero level" at $121.25 has been successfully tested on three occasions since TLT first broke into positive ground for 2012 in May, and its slight penetration on today's pullback represents a shot across the bow to the legions of Treasury bond bulls. The final testing ground for TLT support is the round-number $120 level, and since May, there have been just two trading days on which $120 has been breached on a closing basis.

Regarding the "legions of Treasury bond bulls" to which I just referred, there are signs the herd is beginning to thin, as illustrated in the accompanying chart (courtesy of Trade-Alert), which sets forth the daily TLT put and call open interest from Dec. 31, 2010 to date, along with the TLT price action. The point labeled "A" on this chart represents the peak TLT put open interest over this period, which occurred on Jan. 20, 2012 at 681,000 contracts. And the most recent TLT put open interest peak -- labeled "B" on the chart -- occurred on Oct. 17 at 463,000 contracts. So what are the implications of this 30% decline in peak TLT put open interest since the record-high levels of January?

My take is that the level of put open interest in TLT is a good proxy for the level of long positions in TLT from those who hedge their positions by buying puts for downside protection. And since hedge funds are such major players these days, and hedging with options in general is much more widespread than ever, I would suggest this decline in peak TLT put open interest may well be an early warning indicator of the beginnings of a reduction in the dollars being allocated to long Treasury bond positions by major players. And any further reductions are likely to have a major negative impact on Treasury bond prices, as what was formerly demand becomes supply.


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