Diversifying SPY Exposure with TLT
Sep 7, 2018
Traders looking for different ways to diversify their portfolios, or even simply to add occurrences, will find a new episode of Market Measures to their liking.
The focus of this episode is the TLT, which is essentially a proxy for long-term bonds (20+ years) in ETF form.
A key to understanding the approach presented on Market Measures is to remember that bond prices typically possess a strong negative correlation to interest rates. That means that when long-term interest rates increase, long-term bond prices theoretically decline.
If you want to see an example of this in practice, simply look at the 5-year chart of TLT and you can see that it was at its highest levels when long-term rates were at their lowest. The fact that TLT has trended lower ever since the Federal Reserve ended ZIRP (Zero Interest Rate Policy) is another strong indicator of this relationship.
In addition to the inverse relationship between bond prices and interest rates, it should also be noted that SPY and TLT also share a historically strong negative correlation, as highlighted in the graphic below:
At the least, the above tells us that SPY and TLT don't share much positive correlation - meaning they don’t move together in the same direction very often. For options traders seeking diversification in their portfolios, that's a critical distinction.
For example, if a trader sold puts in both the SPY and TLT, he/she could be relatively confident that both of these underlyings wouldn't be at high risk of a big down on the same day.
The same couldn’t be said for two stocks such as Goldman Sachs (GS) and Microsoft (MSFT), which could theoretically both get caught up in a broad market selloff. Likewise, two different global ETFs, such as FXI (China) and EWZ (Brazil), could also simultaneously be subjected to intense downward pressure during a worldwide selloff.
For more information on the profile of TLT, as well as how it relates to the Treasury Bond Future (/ZB), we highly recommend reviewing this past installment of Market Measures.
Getting back to the topic of diversifying SPY exposure using TLT, let’s now take a quick look at recent research conducted by tastytrade on this topic. In order to help illustrate the power of TLT, especially when used in tandem with SPY, the Market Measures team decided to conduct a historical backtest involving the two.
The strategy backtested was a simple short put approach used in both underlyings (data from 2005 to 2017). In particular, the goal of the study was to investigate how an approach using options compared to a “buy and hold” approach in both SPY and TLT.
As you can see in the chart below, the short put approach in SPY and TLT performed almost identically to the buy and hold approach, but it needs to be noted that the latter approach requires less margin:
(insert image 6 of 9 from August 2nd, 2018 Market Measures)
The above findings provide us with a very important takeaway. If you do consider adding TLT to your portfolio, one avenue to consider may be a short premium approach as opposed to a simply buy and hold. While both approaches have shown historically positive returns, the option strategy has done so while tying up less capital.
Given the importance of this material we hope you’ll take the time to review the complete episode of Market Measures focusing on SPY diversification using TLT when your schedule allows.
If you have any outstanding questions about TLT or bond futures don’t hesitate to leave a message in the space below, or send 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.
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