Since the Presidential election there have been some significant moves in the price of different Treasuries, especially the 30-year Bond. The symbol for Bond Futures is /ZB and the Bonds that are deliverable against the contract can have 15-25 years until maturiry. TLT is an ETF that most closely resembles Bond Futures and is based upon a 20-year index. Although they are similar, there are some important differences, especially in their option pricing. What are those differences and why do they exist? TP joins the guys to explain it all.
TLT is often used as an alternative to /ZB in an equity account. There is no dividend in /ZB though and it has a zero cost to carry. One difference that attracts our interest as premium sellers is that Implied Volatility (IV) in TLT is consistently higher than in /ZB. As you would expect, this means that TLT’s options, on a relative basis, are higher priced. The amount that TLT’s IV is higher changes over time. The reason for the difference in IV is that TLT’s portfolio of Treasuries is more volatile than the Treasury Bonds that would be used to deliver on the Futures contract. They are known as “cheapest to deliver” because they are the least expensive Bonds that would fulfill the specifications of the Futures contract. Since 2011, TLT’s daily returns have been 27% more volatile than /ZB’s. A bar chart displayed the Volatility of daily returns, per quarter, from 2011 to 2016.
Modified duration measures the sensitivity of a Bond or Bond portfolio to a change in interest rates. The higher the modified duration the higher the sensitivity. It’s calculated by taking the net present value of the future coupons (the Bond payments) and adjusting it by the current yield. Longer dated Bonds will have a higher modified duration and modified durations will be higher when yields are higher. TLT’s modified duration is 26 which is 30% higher than the 20 of /ZB. That corresponds to the 31% higher volatility of returns over the past month. Taking the price of TLT and dividing it by the price of /ZB results in a price ratio. That number fluctuates, of course, but is currently around 0.79. We can then take that number and adjust the option prices of Puts and Calls in /ZB for TLT using strikes with the same Delta. A table displayed an example which showed that, when adjusted for price of the underlyings, TLT options are prices around 28% higher which is consistent with both the modified duration and IV.
Watch this segment of Skinny on Options Modeling with Tom Sosnoff, Tony Battista and Tom Preston, aka TP, for the important takeaways and a better understanding of why TLT options are priced higher than /ZB options.
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