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  • Curve Advisor
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    Post count: 612
    #1521 |

    I started the Single Contract, Spread, Single Fly or Double Fly? thread to talk about when you would want to do the various structures. But I have gotten some requests to discuss some other trade structures you can consider. The following will not be any particular order, but I will probably start with options trades, since this has not been discussed much in the Forums.

  • Curve Advisor
    Keymaster
    Post count: 612

    THE CONDITIONAL FLATTENER (OR STEEPENER). PART 1

    The nice thing about options is that it allows you to take a slope (or curve) position, given a move in a particular direction – in other words, “conditional” on whether we rally or sell off. Below are the FOUR categories of conditional slope trades:

    * CONDITIONAL CALL STEEPENER: For example, Buy 2EH (2 year midcurve) 90 calls vs sell 4EH (4 year midcurve) 80 calls. This allows you to express a curve steepening view on a rally. You would want to put something like this on if there are a lot of hikes priced into the whites and reds, and you think on a rally that would be taken out and moved further out the curve. Another scenario where this could work is if you think there could be eases priced into the curve in the next 2 years or so – the reds should lead a rally (give or take some contracts, depending on the environment) when eases are on the horizon. The curve further out should steepen. Each particular environment is going to have its own nuances, and you can teak the contracts as necessary to fit your view. The nice thing about this structure is, it allows you to express a steepening view ONLY on a rally – because your view of the curve may differ on a selloff. You can adjust the strikes as necessary. If you think the only way we rally further is if the Fed eases, you can put this trade on with further OTM strikes. If you like the steepening view at the current rate levels, but are unsure about steepening on a selloff, you can use ATM strikes.

    [to be continued]

  • Curve Advisor
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    * CONDITIONAL PUT STEEPENER: For example, Sell 0EH (1 year midcurve) 90 puts vs Buy 2EH (2 year midcurve) 85 puts. This allows you to express a curve steepening view on a selloff. You would want to put something like this on if you think the the central bank will eventually hike, but not in the next year or so. You may also consider this type of structure if you think the next 12 months are “fully priced”, but on a further selloff, the back end could sell off more. Each particular environment is going to have its own nuances, and you can teak the contracts as necessary to fit your view. The nice thing about this structure is, it allows you to express a steepening view ONLY on a selloff – because your view of the curve may differ on a rally. You can adjust the strikes as necessary.

    * CONDITIONAL CALL FLATTENER: For example, Sell 2EH (2 year midcurve) 90 calls vs Buy 4EH (4 year midcurve) 80 calls. You may want to put something like this on as a play for some sort of QE, or any other scenario where the long end would outperform on a rally.

    * CONDITIONAL PUT FLATTENER: For example, Buy 2EH (2 year midcurve) 85 puts vs Sell 4EH (4 year midcurve) 75 puts. Typically, as hikes are moved forward, they are taken off the long end of the curve. So if you thought hikes were imminent (because risks to growth and/or inflation are to the upside), this type of structure makes a lot of sense.

  • bambam
    Participant
    Post count: 24

    Is there any adjustment to the ratios? or you always do 1 vs 1.?

  • Curve Advisor
    Keymaster
    Post count: 612

    Thank you for the seque into my next few posts…

    You will find from looking at various structures that the (vol) pricing will be such that some of the more “obvious” moves will be priced with a reasonable premium. For example, if you are thinking about a conditional steepener in puts, 0EH ATM (at-the-money) puts will be at a noticeable premium over EDH ATM puts. This is because it is almost a certainty that EDH6-H7 spread will steepen on a selloff, in the current environment. You would also expect 2EH ATM puts to be worth slightly more than 0EH ATM puts, as you would expect EDH7-H8 spread to slightly steepen in a selloff, in the current environment. However, this is less certain, so the premium of 2EH over 0EH puts will be much less than 0EH over EDH.

    Some of the most sophisticated quants and traders in the market model and trade volatility, so you would expect options pricing to be reasonably in-line. However, you can also say the most sophisticated quants and traders model and trade the various STIR futures curves, but there are many times you will find value on the futures curve. And so similarly, if you have a good view on a scenario, conditional on the direction of the move, you may find value in options the pricing.

  • Curve Advisor
    Keymaster
    Post count: 612

    The difference in volatilities across the curve is going to mean a difference in options prices across the curve. When structuring a conditional slope trade, you are going to have many things to decide on:
    * type of structure (for example, conditional put steepener)
    * contracts to use (for example, EDH vs 0EH)
    * strikes to use (for example, EDH 99.50 puts vs 0EH 99.00 puts)
    * structure to use (for example, EDH 99.50 puts vs 0EH 98.75-99.00 put spread)
    * weighting to use (for example, 1:1, 1.25:1. etc)

    This may seem complicated, but it’s a natural trading progression… you start trading in one dimension (i.e. directionally, where you are concerned with just up or down), then you can start looking at two dimensions (i.e. slope and curvature, where you are looking at the relationship between contracts), and then you move to three dimensions (where you add volatility/optionality to the mix). This is not to imply that just trading directionally is inferior in any way. But it’s always good to have more tools in the toolbox, than less. You can take many more types of views based on timing and direction… for example, “if EDH7 gets to 99.25 before March 2016, the Fed will have to do QE4” or “if the Fed hikes in March 2016, EDH6-H7 will be 100+bps.”

    [next: futher discussion of factors]

  • Curve Advisor
    Keymaster
    Post count: 612

    When determining if there is “value” in a conditional slope trade, think about the value of the following two factors:

    1) The value in the current slope between the underlying contracts. You only need value in one direction. For example, you may not have a strong view on whether the curve further out will steepen or flatten on a selloff, but you have a view that the curve further out will steepen on a rally (for example ED10-18 spread). If the underlying curve is already fairly flat, then putting on a steepening view on a rally could be attractive.

    2) The value in the volatility surface. Typically, the volatility of the various options are in-line with reasonable future expectations. However, this may not always be the case – especially for outlier events. So think not just about whether the current ATM volatilities make sense, but also whether the volatilities make sense if rates were to move, say 25, 50 or even 100 bps. There may be value in playing the relative volatility skews of various contracts.

    Ideally, you would want both of the value factors to line up in your favor.

  • Curve Advisor
    Keymaster
    Post count: 612

    Some other things to consider:

    * when setting strikes, consider the historical levels for each of the legs, as well as the historical slope.
    * when setting strikes, consider where you expect the future levels to be for each of the legs, as well as the future slope.
    * when setting strikes, consider any applicable rolldown. For example, if the option expires in 3 months, see where a similar structure is, 3 months earlier. While rolldown is a factor, determine if rolldown is applicable according to your future view.
    * if you need to save some premium, consider thinking about call or put spreads in either or both of the legs.
    * consider the tail scenarios, and what the shape of the curve will be in those scenarios.
    * if you believe an excessively large move is possible, consider purchasing more OTM options vs the OTM options you sell. An unexpected large move will cause volatility to blow out and you would want to own more further OTM options than fewer less OTM options.

    [I may add to this list]

  • Curve Advisor
    Keymaster
    Post count: 612

    [the following will be merged to the above post]
    * when putting on a conditional slop trade, always consider not just what you expect the level of rates (and slope) to do, but that you expect volatility to do.

    [new post:]

    Typically, the goal of putting on a conditional slope trade is to have it be “premium neutral” – that is, you want the cost of the leg you buy to have the same cost as the leg you sell. This way, if the level of rates moves in the unintended direction, your P&L on the trade will be “zero.” Typically, you would put on additional options on the “cheaper” leg, or adjust the strikes as necessary. You can also consider using call or put spreads in one or both of the legs.

    You may have a strong view, or other trades in your book that would disproportionately benefit if the trade did move in the unintended direction (ie you need the protection from the conditional spread trade), that you may want to pay some premium. How high you go will depend on the trade, your positioning and the environment.

  • Curve Advisor
    Keymaster
    Post count: 612

    The trading of conditional spreads allows a natural extension into trading conditional flies:

    TRADING A WEIGHTED FRONT FLY:

    Generally, the volatility on the contracts closer to the front of the curve will be lower than the volatility on the contracts near the “belly” of the curve. This is going to depend on the environment, obviously. For example, if there is only one or two moves priced in the near term, this won’t be the case. But in this environment where multiple hikes are expected, volatility near the belly will be higher. This allows one to put on a “zero cost” weighted conditional spread trade, where you can buy more of the front leg than the back leg. You can think of this as: (1) a weighted conditional spread trade, or (2) a weighted conditional fly trade. For example, if you buy 1.5x 0EZ6 call (1 year midcurve call on EDZ6, expiring in Dec ’15) vs sell 1x 2EZ7 call (two year micurve call on EDZ7 in Dec ’15), you can think about this trade as a fly that is 0.5 x (long cash libor to EDZ6 spread) – 1 x (EDZ6-EDZ7 1 year spread).

  • Curve Advisor
    Keymaster
    Post count: 612

    CONDITIONAL YEAR FLIES

    The midcurve options allow you to take positions on EVERY year fly on the tradeable part of the curve. So you can express an view on not just the current curvature, but for curvature at various rate levels. This is something most people in the market don’t even look at. Part of the reason is that it can be difficult to get such a position on. You can get an options local to make you a market, but if you trade electronically, you will probably have to leg into it (ie do some type of spread vs spread trade). The other part is that you may get “clipped” on one of the legs. For example, if you think the ED9-13-17 fly should be much lower on a 25bp rally, you can buy sell 2E (green midcurve) calls, buy 2x 3E midcurve calls, and sell 4E midcurve calls. This may work out well for a “level” rate move, but if we aggressively bull-steepen, you may find that the 2E calls (you are short) are way-ITM, while the other contracts are way-OTM. However, keep this structure in mind when contemplating on extreme rate moves.

  • Curve Advisor
    Keymaster
    Post count: 612

    Typically, with your options spread and fly trades, you want all your contracts to expire at the same time. However, there may be times when you intentionally want the timing to be different. Some examples include:

    * BULLISH – buying the shorter term call. For example, if you thought the markets would price the Fed to not hike in September, but hike in December, you could do something like buying the EDU5 99.50 calls and selling the EDZ5 99.50 calls, for say 1bp. The premise would be that the EDU5 99.50 calls would be substantially in-the-money, but the EDZ5 calls may lag. In other words, you need to believe the EDU5-Z5 3mo spread will widen as EDU5 rallies. This type of trade would have worked exceptionally well for most of this year, as the Fed sounded like they may hike in June and Sept, but as those meetings approached, the Fed backed off while strongly suggesting a hike later in the year. There will be a decision as to what to do when the EDU5 calls expire. However, the trade at that point may have already made 5-15bps, so any further gains would be gravy. The nice thing about the trade is that if you are wrong and the Fed was actually priced to hike (and eventually did hike), your loss would be somewhat limited, since cash libor should be greater than 50bps after a hike. The caveat however, is that the quarterly Fed meetings generally occur a few days after the options expire, so you would need a very strong view to keep the position on a selloff.

  • Curve Advisor
    Keymaster
    Post count: 612

    * BEARISH – buying the longer term call. In the current environment, with liftoff looming, this type of trade is probably best for ease plays. The longer dated call will generally have more option premium. However, a highly anticipated central bank move may cause certain strikes to get “pinned.” So the longer-dated options will be cheaper-than-normal. I realize playing for an ease is not a high probability event, but this should also be very inexpensive as a result. If it is cheap enough, having some crisis protection in your book is good. Interestingly, the quarterly ED options typically expire a few days before a Fed meeting. So you can also use this structure to play for the markets pricing in a Fed hike, when you believe the Fed will not hike. If you sold the shorter term call that would expire worthless if the Fed hikes, and bought the longer term call that would be in-the-money if the Fed does not hike, you can benefit from the timing of this structure – the shorter term call will expire before the FOMC meeting. You sold the shorter term call to offset some of the cost of the longer term call.

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