Since some of you may be new to ED trading, I may occasionally do a “Trade Basics” segment. 

There was an interesting trade that went through on Friday, and I thought I would discuss it.  Almost 25K EDU7-EDV7 spreads traded.  This is a crazy amount to have traded, considering the open interest on EDV7 is only 103K contracts.  I’m assuming this is probably some kind of unwind.  There appears to be an equally unusually large volume on this spread trade on August 2, and since EDU7 rolls off Monday, it seems reasonable to conclude that this was an unwind of that trade.  But I do think that this particular individual may not have handled this particular position well.  I am not aware of the particular details, so most of this is just based on conjecture.  For all I know, this could have been the hedge to a much better trade, and the overall position was extremely profitable.  I doubt it though.  As I thought about this more, it occurred to me that there are some things we could learn from this episode:

  • There are ED structures on Globex that do NOT feed through to its component contracts. This falls under the “know the details of the product you are trading” basic lesson.  The quarterly contracts feed into the various spreads (EDZ7 and EDZ8 feed into EDZ7-Z8 spread and vice versa).  This may seem very counter-intuitive, but ED serial spreads DO NOT feed in from ED contracts, or vice versa.  This means that the single EDU7 and EDV7 contracts could imply one set of prices, while EDU7-V7 spread shows a completely different price.  I was scratching my head wondering why EDU7-V7 spread was trading 2.75 bps late Friday when the underlying individual contracts were implying a price of 3.1bps.  And the Fed-meeting adjusted value of this spread was 3.7bps.  So this guy was selling EDU7-V7 at lower levels as the Dec meeting was increasing.  It doesn’t happen that often to see a 1 month spread of 3mo ED contracts trade that far off from value.  I suppose if you thought that the libor fixings were going to collapse, it makes sense.  But having a 1bp lower libor target as an over/under in a month seems very aggressive – especially when the Fed is about to taper (and we could reflate).  EDU7 still trades until Monday morning, so this trade may still be there.
    But back to the original point… there are other examples of ED structures on Globex that don’t feed through to its component contracts/structures.  Condors don’t feed into the component spreads.  For example, the markets in EDZ7-Z8-Z9-Z0 1yr condor have nothing to do with the {EDZ7-Z8, EDZ9-Z0} or {EDZ7-Z9, EDZ8-Z0} spreads (you can construct the condor from combinations of these spread pairs).  Similarly, the EDZ7-Z8-Z9-Z0 1 year double fly has nothing to do with the EDZ7-Z8-Z9 1 yr fly or the Z8-Z9-Z0 1 yr fly.  So if you just stick a bid in the double fly structure, that structure may not trade, even if the structure is easily leggable in the single fly market.  You may not get filled unless some local finds some edge in the individual fly markets they are looking for (i.e. unless you are off-market).  For all you scalpers out there, look at the opportunities between these types of structures.
  • Don’t be lazy – you may be better off manually legging. For the love, if the components don’t move much, don’t auto-execute the second leg after the first leg gets filled.  Try working the second leg with a tic.  Many times, the EV of getting filled better outweighs the risk of missing the leg.  I’m really amazed that electronic trading systems don’t have this feature.
  • Don’t have 25% of the Open Interest of a contract, without an exit plan. It could get really ugly if you must get out.  I suspect that he may have been trying to exit EDV7 for at least a week or two because EDV7 started looking very rich to FFs around then.  Maybe this was some kind of debt/budget issue play for mid-October, and the delay until December 15 was not favorable to the trade.  But this is why you need the exit plan!  You just never know what news you are going to get.  I mean was it *that* unlikely a temporary or permanent deal was reached?  There are a lot of events outside of one’s control.  If it was me, I probably would have (1) tried to reduce EDV7 and EDU7 (obviously), (2) bought some EDX7, EDZ7 or even EDH8 (depending on value at the time) to hedge out some of the near-term and longer-term libor narrowing risk) and (3) hedge out the Fed meeting risk of the overall structure (you don’t want to own EDX7, EDZ7 or EDH8 without a Fed meeting hedge).  But I suppose it really depends on why I put the structure on in the first place.  I’m just giving an example of the things you could have thought about.
  • Look at the intrinsic value of a structure. It’s possible this person was stopping out.  But if you can, try to determine what the intrinsic value of this structure is.  EDU7-V7 is basically 31% of the Nov meeting, 31% of the Dec meeting, and some libor basis between the Sept 18 and Oct 16 libor fixings.  You can easily hedge the meeting risk with FFs.  Then you are left with the libor spread risk between the two dates.  But most of the time, we don’t get that sharp a move on the libor-FF curve.  EDV7 also goes over year-end (so we may get a turn) and we do get the Fed taper.  These are some factors that could cause libor-FF to widen by October, and could be reasons to hold on to some of the EDV7, even after EDU7 rolls off.
  • Pace yourself. If you do find yourself with a position that is too large and a time deadline when you want to unwind by (like Monday), try taking off a certain amount every day.  It doesn’t have to be a rigid target, but waiting until the last minute is generally not going to helpful, unless you really believe in the power of prayer.  If you have more time, you can do things like…
  • Avoid crossing the bid-ask on contracts that don’t move. When legging something like EDU7-V7, or anything involving a front-month contract (ED1 or the first few FFs) that doesn’t move much, you may be better off trying to unwind the thing that moves more first (and working the other leg with a tic).  So after 5:55 CST (when the libor fixing comes out), and not including the times around major data or news, the interest rate markets don’t move that much – especially the very front-end.  You are lighting money on fire crossing the bid-ask unnecessarily.  So work the bid in EDV7 and as you get filled, work the EDU7 offer with a tic.  Many times in the CA, I may write out a trade that involves a spread with a front ED or one of the front FF contracts.  I assume you know how to execute optimally and won’t ever hit the bid or lift the offer on a contract that is 50+K up when legging.
  • The final thing we should look for is some kind of similar play in EDF8 in another few weeks. Because if this was a budget/debt play (and he didn’t get canned), maybe he’ll be in there again around the next December 15 deadline.  And I suppose this is the final lesson… always be one step ahead.

Of course, it’ll be “funny” if this guy was some kind of libor genius AND this was a NEW position, AND knew the 3mo libor fixings were going to collapse after Monday.  I would have babbled on about “lessons” in the 25K EDU7-V7 sale like a jackass.  But even if some of my assumptions about this particular trade are wrong, ALL of the above points are still valid.  You would be amazed at how much saving fractional basis points add up over a year.  Picking up frequent fractional basis points can even make up for an otherwise terrible trading year.