[Below is a Trade Thought essay that discusses a real-world application of the options article I wrote for the CME]

 

This will probably be a multi-part series.  This week, I wanted to discuss the pricing of the front options flies.  Clearly from the FFV8 pricing and lack of movement, the markets just do not think the Fed is going to skip in two months.  We can easily cover the skip scenario by buying FFV8.  We should wait until the August meeting has passed in a few days.  I also don’t think the Fed is going to hike more than once a quarter.  Some of the data would have to move in an extremely uncharacteristic way for the Fed to hike more than two times the rest of this year.

So while the essay started off discussing tails, when you can easily cover one tail (by buying FFs) and the other tail is highly unlikely, playing for a limited-risk decay trade could make sense.  There is nothing interesting that can be done with EDU8 options unless you thought that there was a disproportionate risk we can rally or sell off a ton.  But the EDZ8 options still provide an interesting look at value.

I suggested some EDV8 options structures I liked earlier in the week: (Trade H18) Sell EDV8 97.375 straddle vs Buy EDZ8 97.375 straddle @ 4.5 and (Trade H18b) Buy EDV8 97.25-97.375-97.50 call fly @ 3.75.  The reason the trades make sense to me is that I don’t expect a large move in Libor any time soon.  The seasonal drift lower in Libor-FF is probably offset by the Sept meeting gradually getting more priced.  The Sept and Dec meetings have been very reluctant to move.

In that CME article (https://www.cmegroup.com/education/files/curvature-trading-part-three.pdf), I discuss how the options flies (call or put) can be thought of as a probability distribution of contract expiries.

By construction, the sum of all the flies will equal the distance of the strikes – in this case, 12.5bps.  You can see that all for all three options expiries (EDV8, EDX8 and EDZ8), the high options fly is around the 97.25 strike (which corresponds to the market’s central view of roughly two additional hikes by year-end).  You could argue that since all three options contract expiries have the same underlying contract (EDZ8), that you would expect a similar shape to the three sets of fly distributions.  A typical pattern would be that the shorter dated expiry would be more “concentrated” (since there is less time to move), while the longer dated expiry would be more “distributed (since there is more time to move).  That is generally what we see in the pricing.

However, there are a few reasons why I don’t think the current pricing makes sense.  My contention is that the risk on EDZ8 by the time of the EDV8 options expiry is to the upside, while the risk on the EDZ8 at the December settlement is to the downside relative to the EDV8 expiry:

  • Seasonally, Libor-FF tends to narrow over the summer and fall months. While I think the degree of narrowing could be somewhat limited for fundamental reasons (Federal deficit, QE taper), we tend to see a narrowing of ED-FF spreads over the summer and into the fall.
  • EDZ8-FF seems strangely wide relative to the ED-FF curve. We could see a small 1-2bp correction in EDZ8-FF relative to the rest of the ED-FF curve as the summer goes on.
  • As we approach year-end, we tend to see Libor-FF widen. We saw this more last year, and we have a few similar dynamics with a growing budget deficit and a continued QE taper.
  • The largest driver of EDZ8 is going to be Fed hikes through the end of the year. If things stay “on course” (continued gradual growth and stable to uptick in inflation) we should get more of the Dec hike priced into an EDZ8 expiry than an EDV8 expiry. In the near-term, I think there is some room for EDZ8 to rally a few bps.
  • If the Fed does nothing next week, short term vol could come off. I suppose they could hike, but then the Sept meeting could get crushed, which would offset some of the pain.  These are limited-risk trades, so there is no real disaster scenario.  The max risk on both structures may be about 3-3.5bps.
  • Midterm elections. There could be some more uncertainty priced into the elections in the October contract, but after the elections, we could see some relief priced into the markets (regardless of election outcome).  Another reason for the relief could be…
  • Trade tariff negotiations. It is my contention that as we approach the elections, we are more likely to see some deals get done.  So by November, we could see more of the Dec meeting being priced in.  We could also see a resolution before October, but we don’t have to hold the trade to expiry.
  • There is a good chance Kong will be unwinding later in the year. We want to be short EDZ8 closer to year-end when that happens.

As a result of the above, I think the highest 3mo fly in EDV8 should be centered around the 97.375 strike (NOT the 97.25 strike), while the high 3mo fly in EDZ8 should be around the 97.25 strike.  The EDV8 97.25-97.375-97.50 call fly settled (and traded) at 3.75 Friday, even though it is 7.5bps ITM.  This seems like a reasonable play at cheap decay, and one of the reasons I suggested the trade in an email last week.  Normally, you wouldn’t want to have a short gamma trade in this environment (trade tariff risk, FOMC meeting next week, PCE and payrolls).  But I think it’s unlikely that we get a change in the status quo, and even if we do get a change, it’s not clear EDZ8 will move much.  Also, we do plan on having skip protection by buying a nearly “fully-priced” FFV8 or FFX8 after the FOMC.  So that offsets some of the large move potential on the upside.  Finally, even if EDZ8 does move, our downside is limited on a call fly and a straddle spread (which is trying to pin the EDV8 settlement around the 97.375 strike).

We don’t have to hold the trade to expiry… we can just play for a small bounce and unwind if we think EDZ8 goes much past the 97.375 strike.  If EDZ8 sells off because of ED-FF widening, we can also hedge some of the widening via ED-FF trades since about 4bps of narrowing are currently priced into EDU8-FF.

At some point later in the year, I may take a similar look at options in the longer end.