Home Forums Main Forum Single Contract, Spread, Single Fly or Double Fly?

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  • Curve Advisor
    Keymaster
    Post count: 612
    #1213 |

    There are many ways you can express a rates view using ED futures (I will ignore options, for now). For example, say you were bearish. Here are some of the ways you can express a bearish view using futures:

    1) Single future trade. like sell ED9 – 1 contract
    2) Spread trade, like buy ED3-7 spread – 2 contracts
    3) Single butterfly trade, like buy ED 5-9-13 fly – 4 contracts
    4) Double butterfly trade, like buy ED 5-9-13-17 double fly – 8 contracts

    Which is best? The correct answer is… “it depends” – on a lot of things. There is something to be said for KISS (Keep it Simple, Stupid), and there are many in the markets who just trade single contract positions for that reason. However, not knowing what all your alternatives are could result in a sub-optimal positioning choice. The optimal way of expressing a view may involve more than one of the above options.

    In future posts, I will discuss some of the considerations when weighing the pros and cons of the four alternative above.

  • Curve Advisor
    Keymaster
    Post count: 612

    Here are some other classes of trades you can use to express a rates view:

    USING OPTIONS:
    1) Single option trade, like buy EDZ 99.25 puts
    2) Option spread trade, like sell EDZ 99.50 puts vs buy 0EZ (1 year midcurve) 98.75 puts. This is a “conditional steepener” – on a selloff, you expect the curve to steepen.
    3) Option calendar butterfly trade, sell EDZ 99.50 puts vs buy 2x 0EZ (1 year midcurve) 98.75 puts, vs buy 2EZ (2 year midcurve) 98.26 puts. This gets you into a Z-Z-Z fly on a selloff.

    The benefits of using options is that it lets you get into the directional/slope/curve position you are looking for, but only on a selloff. “Typically” the volatility curve prices in a premium for this benefit. But as with all markets, there are many times when something is not correctly priced in. So if the optionality looks “cheap,” expressing a view in options may be preferred.

    [next: using cross-market trades]

  • Curve Advisor
    Keymaster
    Post count: 612

    You can do all of the above in a cross market trade. Global rates tend to move in unison. Sometimes this is “correct,” and other times it is not. If you have a view in one currency, there are times when it makes sense to do the opposite trade in another currency. For example, you can buy a ED3-7 year spread vs sell BA3-7 year spread (Canadian BAX).

    * There may be times when you have a view in one country, but the levels are not compelling enough to do that trade in isolation. However, when looked at comparatively to another country, the trade looks more attractive.
    * This may give you a way to profit in BOTH countries. There will be times when their paths go in opposite directions, and recognizing when this occurs could give you an additional advantage.
    * You can sometimes cancel out some of the daily “noise.” The two economies are neighbors and major trade partners, and their fates are closely linked. So some of the daily P&L noise may be reduced. If the two countries are in noticeably different time zones, you may be increasing the P&L noise, since the closes will be taken at different times.
    * The terms of the contracts do not have to overlap. For example, Canada may be thought of as being 1 year behind the US in terms of central bank actions. So if there is a tight trading correlation seen going forward, and you disagree, you can take the opposite view.

    As you can see, there are many possibilities for structuring a view. [I may add to this]

  • bambam
    Participant
    Post count: 24

    This used to be very useful until a year ago or so,

    specially BA5,BA6, or BA7.
    We paid a lot of attention to the daily change on BA vs daily change on ED. you could see the lag on the reds and the greens (greens are already illiquid on BAs)
    However since the mickey mouse bank surprised everyone and eroded liquidity. The correlation has faded, my guess is that they are repositioning the CA curve to match the FED and then follow the same path once again.

    Have you tried to express the similar concept but on different structures?
    E.

  • Curve Advisor
    Keymaster
    Post count: 612

    As with any kind of “range trading,” the key is identifying when there is a likelihood of a regime change, not just within a country, but in the relationship to the other country as well – for example, switching to being closer to easing while the other country is still closer to hiking would tend to break previous relationships. Of course, it’s always easier to see in hindsight.

    I am going to start looking more at ER in the next few months. I haven’t focused on the other markets because of QE (there are fewer curve opportunities on a flat curve), or because of the lack of volume (a lot of customers aren’t interested unless they can do decent size). But BAs lend themselves well to cross-markets trades because of the strong ties to the US and it helps that we are in similar time zones.

  • Curve Advisor
    Keymaster
    Post count: 612

    People generally start off trading single contracts in EDs. They use them to take simple, directional views on rates, usually based some technicals or fundamentals. A single contract trade can be a fine choice – it’s simple, and typically very liquid. However, it may not always be the best choice. When taking a bullish/bearish view on rates, you need to review all of your alternatives to select the trade that is best risk/reward.

    One alternative to a single contract bear-bull trade is to buy or sell some sort of spread (i.e. buy ED5 vs sell ED13). The enclosed scatter plot shows how the slope (one example is on the y axis) can change with the movement in rates (one example is on the x axis). As you can see, there is a reasonable correlation over a long period of time in the current US environment. Note that I emphasized “current environment” and “US”. Depending on the environment and the country, there could be a different relationship between the level and slope of rates.

    This type of trade is attractive if you think the front contract will outperform on a rally and the back contract will outperform on a selloff. This type of structure requires a little more thought and analysis, and the behavior of the spread could vary depending on the environment / regime. However, you may be rewarded with a better risk / reward trade.

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  • Curve Advisor
    Keymaster
    Post count: 612

    I posted the above chart mainly just to show that a spread has some correlation to the level of rates in this environment. In all my charts, the last close is shown as a black dot. So I thought to myself, that the point looked very low, compared to the level of rates, and I wondered if there was a trade here… basically, I would want to sell ED9 vs some weighting of ED5-13 spread. This is what one would derive from “basic” historical analysis – you look for charts where the current point is at an extreme to the historicals.

    However, as I keep stressing in the Forums, you need to be careful of relying on historicals when the trading regime has changed. In particular, the Fed hiked for the first time last month. This is going to elevate all rates by up to 25bps. One thing we can do is to look at ED5-13 spread as compared to the FF-ED9 spread. As a proxy for the latter, we can use ED1-9 spread as an estimate. Note that the graph is not as attractive looking. It looks somewhat similar (in the big picture), but if you look locally withing the recent cluster of points, the last point (black dot) looks like it is sitting on the trend, rather than slightly below.

    Also note that since we made the adjustment to account for the current FF rate, the bottom clump of dots look more like an straight line, whereas in the previous scatter plot, it looked like an anvil. The base of the anvil started to form after the FOMC meeting. Liftoff caused all rates to be higher than what they would have been in the past.

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  • Curve Advisor
    Keymaster
    Post count: 612

    Viewer Mail: I was looking at the ED Z6/Z7/Z8 fly (currently trading at -0.015) and wondered how you forecast how a rate rise will affect this spread. Imagine I thought the Fed would hold off raising rates for the remainder of 2016 but would likely increase rates by at least 0.25% through 2017 and would continue on a slow path of rate raises (0.25% – 0.50% per year). What is a good way to gauge how the spread would react? Buying the Z6/Z7 spread would seem more appropriate but I have been told that flys and double flys are useful in mitigating curve risk. What are your thoughts on such a play? TIA.

    If you think the Fed raises rates for primarily for 2017, then your three main choices are (not in any order, since I don’t know what your specific view is):
    * sell EDZ7. This could be best if you think the curve is too flat (so your downside is limited), and you want the ease of execution. This could get smoked on data terrible enough for a substantial ease to be priced in. However, you also benefit from any hikes priced into later this year.
    * buy EDZ6-Z7 spread. This is only good if you think EDZ6 could rally some on a disappointing number. I’m not sure there is enough room for EDZ7 to rally on a mildly disappointing number (since EDZ6 is so high already). It’s possible on a catastrophically bad number, we could price in an ease, that could save you some P&L than just being short EDZ7. However, on a very strong number, EDZ6 may eat into your profits on a selloff.
    * buy EDZ6-Z7-Z8 fly. This is similar to the EDZ6-Z7 spread, but works best if you think in a selloff, Z7-Z8 could flatten. Normally, a selloff would be led by the greens, but in this yield-grab environment, the curve could keep flattening. So if your hike view is limited to 2017, this could be a good choice. This could also offer some protection if you think Z7-Z8 spread could flatten on a rally.

    I could post some historicals, but Brexit has made most historicals prior to the past two weeks fairly useless. Note that some versions of a bearish trade may move less, so you may need to size the above structures differently to get the same amount of “kick” (P&L) on a bearish move.

  • Curve Advisor
    Keymaster
    Post count: 612

    Viewer Mail: I was reflecting on some of my losing trades and I’m coming around to thinking I have been too conservative in my trading strategies. Where I have used butterfly’s to manage my risk, all I ended up doing was introducing another variable (a second calendar spread) that could go against me, as well as hurting my risk/reward ratio with the additional legs. In hindsight, I would have done much better just trading a simple two-leg calendar spread. I wonder if you have any thoughts on this topic?

    It’s hard to say in a vacuum without knowing what trades you are doing and what your specific views were. But the main thing I think you should do is to diversify your view. Rather than put all your eggs in one basket, have a few variations of the view on (each in smaller size). Sometimes relative value trades (like flies) may not kick in right away. If you diversify, and your view materializes, you can take profit on the outperformers and you have the option of adding to the underperformers.

    You probably only want to diversify a directional view only when your alternatives are somewhat close in ev (expected value). Just think about the various scenarios and think about what the curve will look like on various outcomes. Which ones make the most when you are right and lose the least when you are wrong? The curve rarely moves in a straight line, and the upmoves and downmoves are rarely symmetric. This allows you to pick structures that have positive ev payouts.

    The two general approaches you can take to look at scenarios are: (1) event-driven, or (2) move-driven. An example of event-driven would be thinking about a {-100, 0, +100} surprise in payrolls and what the curve would look like. An example of move-driven would be thinking about what the curve should look like on a +10bp move and a -10bp move. Just as an exercise, think about what you think the curve would look like on various data surprises and try to understand the resulting curve moves. This will give you some practice in determining which of the various trade structures (single contract, spread or fly) would have been best. Keep in mind you probably want to size smaller on a single contract trade than a spread, and smaller on a spread than a fly.

  • Curve Advisor
    Keymaster
    Post count: 612

    Viewer Mail: An area of curvature trading that I’d like to hear a bit more on is trade selection.
    Just considering ED, how do you go about narrowing down the (very) large combinations of calendar spreads, butterflies, condors, etc that are possible among all the available contracts (months and years)? I haven’t calculated the number but there are certainly hundreds of possible combinations that could be traded at any point in time. How do you start with this large set of possibilities and narrow it down to a few which are viable trade candidates?

    It’s a matter of having a view on the richness/cheapness of the various parts of the curve. You can have an absolute view (i.e. the Z6-Z7 spread is too low), or a relative view (i.e. the Z6-Z7 is too high, relative to the Z7-Z8 spread).

    How do you develop a “view”? The primary way is based on “fundamentals”. Think about the things driving rates (FOMC, supply/demand, market psychology, economic and news calendar, etc). Weighing all of the factors driving rates, you should have some views (both absolute and relative) on the various parts of the curve.

    You can also use “secondary” sources of information, like technicals or historicals to add or subtract from the strength of that view. I know there are people who rely on these as “primary” sources of a view. But the fundamentals should always take precedence in my opinion. People who rely solely on historicals generally don’t do well (unless they happen to pick a period of time that corresponds to historicals).

    Finally, you should always stress test that view. One way is to look at scenarios. Think about what the entire curve would look like in the current environment on a “25” bp rally and a “25” bp selloff. How does your structure perform? Is there a structure that would perform better? Another way to “stress test” is to discuss with a colleague/friend. Have someone who can challenge your view and give you factors you may not have thought of.

    Combining all of the above should point you in the right direction in terms of picking the best structure to fit your view.

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