How to Respond to Bond Market Volatility

On Aug. 21, Bloomberg posted an article about famed short-seller Michael Burry, who made a name for himself by betting against and ultimately calling the housing bubble. The article disclosed Burry was eyeing his next house of cards; long-term treasury ETF's. Burry's fund purchased $280 million in puts against the iShares 20+ Year Treasury Bond ETF (TLT) at the end of June, at a time when TLT was trading at multi-month highs. It's not uncommon for news outlets to latch onto such stories, given Burry's success in nailing the housing market collapse. Fast forward one month and one sharp selloff later, Burry's bet takes on an entirely different tone.

On Sept. 23, TLT sat just below $153 and it's 320-day moving average. By the Sept. 28 close, the ETF traded at $144, a roughly 5% pullback in less than five trading days, attributed to the 10-year Treasury yield climbing to multi-month highs in conjunction with Federal Reserve rhetoric about scaling back bond-buying measures in the coming year. That Sept. 28 level was its lowest since July 2, breaching a host of shorter-term moving averages, as well as its 100-day trendline.

It's no surprise then, that TLT's 14-Day Relative Strength Index (RSI) drifted into oversold territory, breaching 35 on Sept. 28. Per the chart above, the last time TLT's RSI was that low, it preceded a channel of higher highs from the ETF that lasted until early July. That's not necessarily a buy signal that can stand on its own, but when combined with other factors, is worth considering.

One such factor is that options traders have been focused on TLT puts for some time now. During the past 50 days, traders on the International Securities Exchange, Chicago Board Options Exchange (CBOE), and NASDAQ OMX PHLX (PHLX) have bought to open 2.14 puts for every call on TLT -- a ratio that registers in the 92nd percentile of its annual range. The ratio crossed 1.0 – which indicates puts outnumber calls on an absolute basis – back in April. In the wake of last week's selloff, put traders are growing as bolder; the ratio sits at its highest level in over a month.

Can contrarians take advantage of this building pessimism? TLT's 4% drop in five days is a noteworthy indicator. According to Schaeffer's Senior Quantitative Analyst Rock White, there have been 29 other occurrences of drops of 4% or more since 2002. Per the table below, the one-and two-week returns signal outperformance compared to TLT's anytime performance. The ETF was up an average return of 0.8% after two weeks, compared to the anytime return of 0.2%. After one and three months, the returns are closer to normal. For investors looking to buy the dip, this paints a picture of TLT being extremely elastic and responsive to quick bounces following drastic pullbacks.

If you're sold on the historical context, there are longer-term moving averages that should be monitored. The CBOE U.S. 10-year Treasury Index's (TNX) 36-month moving average, which equates to three years, has been a trendline of interest dating back to 2004. Per the chart below, cultivated by Schaeffer's Senior V.P. of Research Todd Salamone, 2004-2005 and 2011 are the only instances per year that this 36-month trendline didn't act as either support or resistance, with crosses above or below serving as fake-out moves. With that moving average now serving as resistance, it can act as a signal for those options traders – and possibly Michael Burry – as to how their bearish bets could fare.