Almost two months ago, I was watching some large players sell the EDZ7 98.50 straddle for about 6-7.  At the time, libor-FF was very stable, but it was not a “sure thing” that the Fed was going to hike in Dec (maybe around 80% priced).  I didn’t have a strong view on the level of the straddle.  It seemed like it was very fractionally positive EV at the time.  But I prefer finding “zero cost” ways of owning the tails, rather than being short volatility in this environment.

Well, lo and behold, we got a funding “event” and that EDZ7 98.50 straddle is now 12.5.  I really was not expecting libor to have made such a large move.  But year-end fixings can be very noisy.  And this year is noisier than most, with the new tax legislation (repatriated profits), the large number of shorts and the repo squeeze, and the budget negotiations.

I feel like it’s Groundhog Day, with the EDH8 98.25 straddle at 9.5 with three months to go (an extra month than the EDZ7 example).  I could understand why someone would want to sell the EDZ7 98.50 straddle in October.  Libor-FF had been fairly stable for months, and the Dec hike looked like an 80% certainty.  The March meeting is less than 70% priced, and I’m not sure if the next 3bps in libor-FF is going to be lower or higher.

The reason why straddles under 10 are interesting is because from a theoretical standpoint, the Fed moves in 25bp increments.  So if a strike happened to right at the center, you know the straddle has to be worth at least 12.5.  Otherwise you would be giving the tail probabilities away for free.  This was more useful when trading Fed Funds options (back in the day when they traded).  The outcomes were discrete (0, +25, -25, +50, etc), so you had to use discrete models to price options.

In the case of EDH8, we have two additional variables: (1) the noisiness of the libor fixings and (2) EDH8 settles before the FOMC meeting, so rather than having a 0 or 25bps priced, the range could be narrower (say 2 to 23 bps, instead of 0 to 25 bps).  I could see why someone could think that EDH8 could fix around 98.25.  EDH8 could price in less than a full 25bps.  And I could see why people would think libor could settle down early next year.

But for most of the hikes in this cycle, the Fed has telegraphed well-in-advance whether or not they are going to hike.  So we could get very close to the full 0 to 25bp range.  And I’m not so sure libor couldn’t continue to be noisy.

I do think there could be some value in EDH8 options.  We bought some EDF8 calls because they were “free.”  I suppose we technically got paid to own them, although there would have been more noise/pain in the “skip Dec” scenario because of the libor widening.  But it seems like the EDH8 options could provide some value if you had a strong view – especially on the bullish side.  EDH8 98.25 calls are 3.75bps.  Assuming libor-FF stays here (I know – big assumption), these calls could rally to maybe 17bps on a skip?  There are about 13.5bps of profit, assuming a full 0 bps are priced.  So we may need to shave that a little.  Say it’s 12bps, since the Fed has been telegraphing.  The risk/reward on these seem better than on the FFs.

There are a lot of wildcards to factor in – less telegraphing of Fed policy under Powell (so the straddle does not get extreme), more libor noise, and increased decay.  The latter could be painful, because EDH8 could just sit here, going into the Fed meeting.  But we do get a lot of bullish protection.  We are getting very close to the point where EDH8 calls could look attractive to FFs.  We may already be there.  Let’s wait for some stabilization in libor before doing this, but I wanted to put it on your radar.