From time to time, I’ll post an occasional trade.  You’ll need a reasonable cost structure to take advantage of this opportunity.

On Friday I sent out the following trade:

I saw EDZ7 98.625 call trade 1.5 and that seemed really cheap.  The premise of the trade is to get a “zero cost” straddle.  In fact, according to my numbers, I think you GET PAID for owning this straddle.  This would be to buy 100 EDZ7 98.625 call vs Sell 12 FFF8.

I’ll do the full write-up this weekend.  But basically, the EDZ7 call traded 10K times at 1.5.  FFF8 should fix around 98.596 on a hike and 98.846 on a skip.  On a hike, you lose 150bps on a 100 lot of the EDZ7 call, and you make 168bps on the FFF8 (assuming you sell 98.68 – bid there), for a net of +18bps on a hike.  The skip scenario is a little more complex, because it all depends on where you think EDZ7 fixes on a skip.  I’m assuming 98.675, but I think if libor continues to fix lower, there is more upside on the trade.  You will make 350bps on the calls (net 3.5bps on each call) and lose 332bps on the FFF8.  So you make a little in each scenario.  You can re-weight as you see fit (EDZ7 settle assumptions, or a bearish/bullish bias).  BUT THE MAIN REASON TO DO THIS TRADE IS FOR THE GAMMA.  In particular, if the Fed has to ease or vol spikes higher for any reason, you can make a ton of money.  I’ll do 20 of 40 units here.  I think the Fed is hiking unless something is wrong, so I like it as a protection trade.  

You just need to buy the calls @ 1.5.  You can then work the FFF8 @ 68.5 with a tic.  If you are nervous the markets could price in a Jan hike, you can sell FFG8 instead.

We settled at the levels we wanted to do the trade (1.5bps on the EDZ7 calls and 98.68 in FFF8).  Let’s look at the scenarios, assuming we bought 100 EDZ7 calls and sold 12 FFF8 contracts (20% DV01).

1. On a Dec hike.

This is fairly straight-forward because we lose 1.5bp premium on the calls, and we make 8.4bps on the FFF8.  That’s a loss of 150 total bps (1.5 x 100 contracts) on the calls, and a gain of 168 total bps (8.4 x 20) on the FFF8.  FFF8 went offered post-settle on Friday, so if you were to sell a half bp lower (98.675), that would effectively reduce the gain to 158 total bps (7.9 x 20) on the FFF8, for a net gain of 8bps.  This isn’t a lot.  But you can always reweight the trade to be more bearish on a pop in FFF8.

2. On a Dec skip.

The easy part is figuring that you would lose 332 total bps (16.6 x 20 contracts) on the FFF8.  The tricky part is trying to figure out where EDZ7 settles on a skip.  Libor is going to be noisy – we have the year-end turn, a Fed meeting (EDZ7 settles 3 days afterwards), and a debt/budget deadline the business day before.  In my email, I assumed that EDZ7 would fix at 98.675 on a skip, but that was being conservative.

I think 98.686 is a more reasonable assumption (EDZ7 rallies the same 16.6 bps as FFF8 on a skip).  This would assume the current EDZ7-FF spread remains the same and the pricing of the Jan meeting remains the same.  This would mean we would make 6.1bps less the 1.5bp cost, for a net gain of 4.6bps.  This would result in a gain of 460 total bps (4.6bps x 100 contracts).  Now, there is both upside and downside risk to this number.  The upside would be if EDZ7 rolled down an additional 1.3bps (to where libor-FF currently is).  That would be an additional gain of 130 total bps.  Of course, libor-FF could creep higher than is currently priced.  That is a risk.  But just to give ourselves a buffer, I just assumed we would fix around 98.675.  Yes – there was some finger-wagging involved.  But it is possible EDZ7 is getting dragged lower from EDV7 and EDX7 currently trading rich to the ED-FF curve.

If you are reasonably certain the Fed hikes in Dec, you don’t have to concern yourself as much with the skip risks.  The EDZ7 expires AFTER the Fed meeting, so a reasonable premium for the optionality in the calls should still be present, up to the FOMC meeting.  As a result, we may be able to squeeze a little more profit if we unwind before the meeting (rather than as a terminal trade).

There are some tail scenarios we should consider.  The good tails are why we do the trade:

  • GOOD 1: If the Fed has to ease… say everyone is right and we get a 40% drop in equities in October, or North Korea nukes Tokyo, or we get some horrific economic data (we do get three payrolls by the Dec meeting), etc. The list of possibilities is long.  One ease will make your year.  You may even be able to retire if the Fed just went back to 0%.  This is because you are effective net long 80 EDZ7 calls on a large rally.
  • GOOD 2: If for some reason Esther George cast a spell over the FOMC and they hike in both November and December, or we got some crazy inflation scare where the Fed hikes 50 in December, you just made your year.
  • BAD: The main bad scenario would be if we had some kind of libor blow-out or widening. It’s possible the FF could price in a skip (or even an ease) and EDZ7 do nothing.  But considering EDX7-FF is BELOW libor-FF, this is an easy hedge (at least in the short term) for the next month or so.  So if you have any kind of EDX7-FF widening trade, this is a nice compliment to the trade.  As long as we are aware of the risk, I think this could be an easy hedge or unwind, when the first signs of stress appear.  No one is looking for this type of stress currently.

I’m thinking that perhaps I should have sold 1 or 2 more FFF8 (to 13 or 14 vs 100 EDs), but being conservative ahead of a potentially volatile payrolls makes sense.  We could always add a little to our FFF8 shorts on a pop, if we still like the idea of a Dec hike.  You should adjust the number of FFF8 to fit your directional view.  The trade is positive gamma after all.