Chapter 10
Wagging the Dog: Interest Rate Futures
In This Chapter
Centering on bonds
Comparing the full spectrum of interest rates
Managing price risks by trading interest-rate futures
Trading short-term interest in Eurodollars and T-bills
Trading longer-term interest-rate futures
The bond market rules the world. Everything that anyone does in the financial markets anymore is built upon interest-rate analysis. When interest rates are on the rise, at some point, doing business becomes difficult, and when interest rates fall, eventually economic growth is energized.
That relationship between rising and falling interest rates makes the markets in interest-rate futures, Eurodollars, and Treasuries (bills, notes, and bonds) important for all consumers, speculators, economists, bureaucrats, and politicians.
Bonding with the Universe
At the center of the world’s financial universe is the bond market. And at the center of the bond market is its relationship with the United States Federal Reserve (the Fed) and the way the Fed conducts interest-rate policies.
By law, the Fed’s two main functions are
Creating and maintaining conditions that keep inflation in check
Maintaining full employment
Full employment is viewed by some as being potentially inflationary because it creates a scenario of too much money chasing too few goods and services — a primal definition of inflation that’s not far from also defining capitalism.
Inflation decreases the return on bondholders’ investments, acting the way sunlight does to a vampire. When you buy a bond, you get a fixed return, as long as you hold that bond until it matures or, in the case of some corporate or municipal bonds, until it’s called in. If you’re getting a 5 percent return on your bond investment and inflation is growing at a 6 percent clip, you’re already 1 percent in the hole, which is why bond traders hate inflation.
The connection between the bond market, the Federal Reserve, and the rest of the financial markets is fundamental to understanding how to trade futures and how to invest in general. In the next section, I discuss the most important aspects of how it all works together.
Looking at the Fed and bond-market roles
The Fed cannot directly control the long-term bond rates that determine how easy (or difficult) it is to borrow money to buy a new home or to finance long-term business projects. What the Fed can and does do is adjust short-term interest rates, such as the interest rate on Fed funds, the overnight lending rate used by banks to square their books, and the discount rate, or the rate at which the Fed loans money to banks to which no one else will lend money.
As the Fed senses that inflationary pressures are rising through analyzing key economic reports, such as consumer prices, producer prices, the employment report, and its own Beige Book (see Chapter 6), it starts to raise interest rates. The Fed usually raises the Fed funds target rate, which focuses on overnight deposits between banks. Occasionally, when the Fed wants to make a point that it’s in a hurry to make rates rise, it also raises the discount rate, the rate that the Fed charges banks to borrow at its discount window, which usually is a loan of last resort for banks and a signal to the Fed that the individual bank is in trouble. When the Fed raises the Fed funds and/or the discount rates, banks usually raise the prime rate, the rate that targets their best customers. At the same time, credit-card companies raise their rates.
As the bond market senses inflationary pressures are rising, bond traders sell bonds and market interest rates rise. Rising market interest rates usually trigger rate increases for mortgages and car loans, which usually are tied to a bond market benchmark rate. For example, most 30-year mortgages are tied to the interest rate for the U.S. one-year Treasury note. I know that sounds confusing, but that’s the way these things are structured.
When it comes down to recognizing when inflation is lurking, sometimes the bond market takes action ahead of the Fed, but other times the Fed is ahead of the market. Sometimes the bond market senses inflation before the Fed does. When that happens, bond prices fall, market rates rise (such as the yield on the U.S. ten-year T-note), and the Fed raises rates if its indicators agree with the bond market’s analysis. Whenever the Fed disagrees with the markets, it signals those disagreements usually through speeches from Fed governors or even the chairman of the Fed. Interest rates are a two-way street: The bond market sometimes disagrees with the Fed, and the Fed sometimes disagrees with the market.
Disagreements between the Fed and the bond market usually occur at the beginning or at the end of a trend in interest rates. Say, for example, that the Fed continually raises interest rates for an extended period of time. At some point, long-term rates, which are controlled by the bond market, begin to drop, even though short-term rates are on the rise. Falling long-term bond rates usually are a sign from the bond market to the Fed that the Fed needs to consider pausing its interest-rate increases. The opposite also is true: When the Fed goes too far in lowering short-term rates, bond yields begin to creep up and signal the need for the Fed to consider a pause in its lowering of the rates.
The Federal Reserve lowers interest rates in response to signs of a slowing economy. Two dramatic examples came in the period after the 9/11 attacks on the World Trade Center, when the central bank lowered interest rates dramatically. The first one came immediately after the attacks when the Federal Reserve lowered interest rates aggressively starting on September 17, 2001, with the Fed Funds rate reaching an all time low at 1 percent.
Another example, one in which the Fed acted with some nuance, came in 2007. The nuance came in the Fed’s clear delineation between its use of the discount rate and the Fed Funds rate, something that the central bank had not done in recent times to any extent.
In this case, the Fed used the discount rate, which is meant to target the banking sector rather than the consumer sector. In August 2007, the Fed lowered the discount rate alone, as it was trying to encourage banks to borrow from the discount window during the subprime mortgage crisis.
The Fed then lowered the Fed Funds rate and the discount rate a second time on September 18 and continued to lower them into 2008 as the U.S. economy continued to show signs of slowing. In January and February 2008, the U.S. employment report actually showed job losses, usually a sign of major trouble in the economy. See chapter 6 for more on the importance of the employment report in the U.S.
The Fed aimed its August discount rate cut by saying that the purpose of the change in the rate was to “promote the restoration of orderly conditions in financial markets, to which end the Federal Reserve Board approved temporary changes to its primary credit discount window facility.”
In the statement announcing the Fed Funds rate and the second discount rate cut, the Fed noted, “Today’s action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time.”
The bond market responded to the Fed’s initial discount rate move with a nice rally. But the second move, because it came with a Fed Funds rate cut, led to a decline in the bond market, raising interest rates. By October, though, the bond market had started to rally again, as signs of a weakening economy, and thus the potential for a decline in inflation, began to surface.
Hedging in general terms
In general, hedging is taking a position in the market that’s in the opposite direction of a trading position you’ve already established; it’s a form of insurance against a reversal of trends. You need to know what the opposition is doing anyway so that you’re better able to make your market move. In the world of short-term interest rates, aside from speculators, the big money comes from money-market funds and corporations.
Generally, money-market fund managers and corporate traders go long or short in the direction that’s opposite their borrowing or lending. Borrowers generally want to hedge against rising interest rates, so they tend to short the market. That way, if interest rates rise, they either reduce their future interest-rate costs or actually profit from the situation.
Money-market funds and corporations borrow and lend millions of dollars on a daily basis, so the short-term interest-rate market, especially in Eurodollars and related contracts, is the way they hedge their exposure. Here’s how hedging works for the various participants:
Lenders: Banks and other lending institutions want to hedge against falling interest rates, so they tend to be long on the market. They know that they’ll be lending money to someone in the future, and if interest rates continue to fall, their profits will be reduced accordingly. By using futures strategies, they lessen the impact of having to charge less interest and thus help curtail potential future losses.
Institutions decrease their risk when they sense that rates are going to fall by establishing long positions in bonds, T-bills, or Eurodollar futures contracts in order to protect their future earnings. The money that they make when they sell their contracts goes to the bank’s bottom line, balancing revenue lost from lending to customers at lower interest rates. This strategy is by no means perfect, but if the institution does it correctly, it at least cushions the blow.
Corporate treasurers: These big-money institutions use sophisticated formulas based on the need to protect their cash flow and future expenses. They also hedge against the risk of adverse international and geopolitical events and against nonpayment by high-risk customers by using the short- and long-term interest-rate futures markets.
For example, say you’re the chief financial officer at an international paper products company that has multiple risks, such as the price of lumber and pulp to make paper and related products and a large customer base in Latin America, meaning that political instability is a major factor you must consider when running your business. By using lumber futures and currency hedges and by varying your strategies based on market conditions and analysis, you can decrease the risk of material shortages and political instability to your company’s earnings.
Speculators: Traders just like you and me always want to trade with the trend, which is why technical analysis (see Chapter 7) is so helpful in futures trading. By the time a tick is printed on a chart, it’s as good of a snapshot as there is for all hedging and speculating that has taken place up to that instant in time.
Speculators generally trade on the long side when a particular market is rising and then go short when the market is falling. Speculative hedging techniques often involve setting up option strategies that are the opposite of established trading positions, such as buying stock index put options on the S&P 500 to hedge a long S&P position.
The same is true when you have a short position. In that case, speculators may buy call options on the S&P 500 or other stock index futures such as the E-mini.
In a flat market, a speculator can write S&P 500 calls to hedge the same long position. And you can use intermarket trades. I discuss the basics of the options markets in Chapter 4. For example, if you have a long dollar position and you’re not sure that the market is topping out, but you’re not quite ready to sell your position, you can consider buying a gold call option because gold tends to rise when the dollar falls. (For more about speculating strategies, see Chapter 8.)
Globalizing the markets
Globalization, or essentially the spread of capitalism around the world, has increased the number of short-term interest-rate contracts that trade at the Chicago Mercantile Exchange (CME) and around the world. Although details of market globalization are not the focus of this chapter, you nevertheless need to know that these contracts exist and that the volume of trades at times is just as heavy in Eurodollars as it is in T-bills.
In fact, just about every country in the world with a convertible currency has some kind of bond or bond futures contract that trades on an exchange somewhere around the world. The following are not complete lists, but they offer snapshots of some of the more liquid contracts.
Short-term global plays include the following:
Fed funds futures: Fed funds futures trade on the CME and are an almost pure bet on what the Federal Reserve is expected to do with future interest rates. Fed funds measure interest rates that private banks charge each other for overnight loans of excess reserves. These interbank loans usually are intended to square or balance the books of the banks involved. The rates often are quoted in the media. Each Fed funds contract lets you control $5 million and is cash settled. The tick size as described by the Chicago Board of Trade (CBOT) is “$20.835 per 1/2 of one basis point (1/2 of 1/100 of 1 percent of $5 million on a 30-day basis rounded up to the nearest cent).” Margins are variable, depending on the tier in which you trade, and they range from $304 to $1350 and $225 to $1000 respectively, for initial and maintenance margins. A tier is just a time frame. The longer the time frame before expiration, the higher the margin. For full information, you can visit the CBOT’s margin page at www.cbot.com/cbot/pub/page/0,3181,2142,00.html#1b. Fed funds contracts are quoted in terms of the rate that the market is speculating on by the time the contract expires, and they’re based on the formula found at the CBOT: “100 minus the average daily Fed funds overnight rate for the delivery month (for example, a 7.25 percent rate equals 92.75).”
LIBOR futures: These futures are one-month, interest-rate contracts based on the London Interbank-Offered Rate (LIBOR), the interest rate charged between commercial banks. LIBOR futures have 12 monthly listings. Each contract is worth $3 million. The role of LIBOR futures is to offer professionals a way to hedge their interest portfolio in a similar fashion to that offered by Eurodollars. The minimum increment of price movement is “0.0025 (1/4 tick = $6.25) for all contracts. The major difference: Margin requirements are less for LIBOR, at $743 for initial and $550 for margin maintenance, compared with margins of $-1013 and $750 for respective Eurodollar contracts. A good way for a new trader to decide between the highly liquid and popular Eurodollar and LIBOR contracts — which offer essentially the same type of trading opportunities — is to paper trade both contracts after doing some homework on how each contract trades.
The LIBOR contract was very important for traders and hedgers in 2007, as the initial liquidity problems from the subprime mortgage crisis occurred in Europe. Because of the LIBOR contract, both sides — hedgers and speculators — were able to profit or to some degree protect their own side of the ledger.
It’s easy to be put off by the large amounts of money that are held in futures contracts, such as the $3 million in a LIBOR contract. No matter what contract you trade, though, you need to think in terms of short holding periods, especially if the position is moving against you. Consider how much you may actually have to pay up (if you’re long) if you don’t sell before the contract rolls over (the amount specified by the contract — $3 million). Small traders usually trade Eurodollars, while pros with large sums and more experience tend to trade LIBOR. See the section “Playing the Short End of the Curve: Eurodollars & T-Bills,” later in this chapter.
Euroyen contracts: These contracts represent Japanese yen deposits held outside of Japan. Open positions in these contracts can be held at CME or at the SIMEX exchange in Singapore. Euroyen contracts are listed quarterly, trade monthly, and offer expiration dates as far out as three years. That long-term time frame can be useful to professional hedgers with specific expectations about the future.
CETES futures: These 28-day and 91-day futures contracts are based on Mexican Treasury bills. These instruments are denominated and paid in Mexican pesos, and they reflect the corresponding benchmark rates of interest rates in Mexico.
Longer-term global plays include Eurobond futures. The Eurobond market is composed of bonds issued by the Federal Republic of Germany and the Swiss Confederation that usually are the second most traded bond futures contracts in volume after the U.S. Treasury bonds. On some days, however, they can trade larger volumes than U.S. Treasuries.
Eurobonds come in four different categories: Euro Schatz, Euro Bobl, Euro Bund, and Euro Buxl. The duration on each respective category is 1.75 years, 4.5 to 5.5 years, 8.5 to 10.5 years, and 24 to 35 years. The contract size is for 100,000 euros or 100,000 Swiss francs, depending on the issuer. Eurobonds can be traded in the United States. The basic strategies are similar to U.S. bonds because they trade on economic fundamentals and inflationary expectations, and they respond to European economic reports similar to the way U.S. bonds respond to U.S. reports.
Some particulars about Eurobond futures:
Foreigners hold half of all Euro Bunds.
Euro Bunds are the most active Eurobond contract traded at the totally electronic Eurex Exchange in Frankfurt.
Both Euro-Schatz and Euro-Bobl contracts rank in the top ten of all futures contracts in global trading volume.
Yielding to the Curve
The yield curve is a representation on a graph that compares the entire spectrum of interest rates available to investors. Figures 10-1 and 10-2, respectively, are excellent illustrations of the U.S. Treasury yield curve and rate structure at a time when inflationary expectations are under control and the economy is growing steadily. The curve and the table are from July 1, 2005, just 2 days after the Federal Reserve raised interest rates for the ninth consecutive time in a 12-month period.
Figure 10-2 depicts a standard, table-style snapshot of all market maturities for the U.S. Treasury. You can view a good yield curve daily in Investor’s Business Daily, either in its digital newspaper or the newsstand version.
As you review Figures 10-1 and 10-2, notice the following:
The longer the maturity, the higher the yield: That relationship is normal for interest-paying securities, because you’re lending your money to someone for an extended period of time, and you want them to pay you a premium for the extra risk.
The yield on all securities rose: Starting with the 3-month Treasury bill (T-bill) and ending with the 30-year bond, all yields rose, compared with the previous week and month, after the Fed raised interest rates. That’s because the Federal Open Market Committee (FOMC), in remarks made after announcing the most recent rate increase in the Fed funds rate, told the market that inflation was controlled, but economic growth still warranted a “measured” pace of continuing interest-rate increases. To a bond trader, that meant that the Fed would continue raising interest rates until it otherwise saw fit, and it meant that the economic perceptions of the bond market and the Fed were in agreement.
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Figure 10-1: A U.S. Treasury yield curve describes the interest-rate differential between long- and short-term interest rates. |
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Figure 10-2: A U.S. Treasury summary shows all the common maturity listings and the price changes. |
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Deciding Your Time Frame
From a trader’s standpoint, you want to consider trading the short term, the intermediate term, or the long term.
Each position has its own time, place, and reasoning, ranging from how much money you have to trade to your individual risk tolerance, and whether your analysis leads you to think that the particular area of the curve can move during any particular period of time.
A quick-and-dirty rule of thumb is that the longer the maturity, the greater the potential reaction to good or bad news on inflation. In other words, the farther out you go on the curve, the greater the chance for volatility.
Eurodollars are the best instrument for trading the short term, because they are liquid investments, meaning that they’re easy to buy and sell because the market has a large number of participants. The opposite of a liquid market is a thin market, in which the number of participants tends to be smaller, the spread between bid and offer prices tends to be farther apart, and the potential for volatility is larger. Grain markets can be thin markets (see Chapter 16). For long- and intermediate-term trading, you can use the 10-year T-note and 30-year T-bond futures.
Eurodollars are well suited for small traders, because margin requirements tend to be smaller, and the movements can be less volatile; however, don’t consider those attractive factors a guarantee of success by any means. Any futures contract can be a quick road to ruin if you become careless.
Ten-year T-note and T-bond futures can be quite volatile, because large traders and institutions usually use them for direct trading and for complicated hedging strategies.
You can use options and exchange-traded mutual funds (ETFs) for trading all of these interest-rate products by applying the basic options and ETF rules and strategies described in Chapters 4 and 5.
Shaping the curve
Several informative shapes can be seen on the yield curve. Three important ones are
Normal curves: The normal curve rises to the right, and short-term interest rates are lower than long-term interest rates. Pretty simple, eh? Economists usually look at this kind of movement as a sign of normal economic activity, where growth is ongoing and investors are being rewarded for taking more risks by being given extra yield in longer-term maturities.
Flat curves: A flat curve is when short-term yields are equal or close to long-term yields. This type of graph can be a sign that the economy is slowing down, or that the Federal Reserve has been raising short-term rates.
Inverted curves: An inverted curve shows long-term rates falling below short-term rates, which can happen when the market is betting on a slowing of the economy or during a financial crisis when traders are flocking to the safety of long-term U.S. Treasury bonds.
Checking out the yield curve
By keeping track of the yield curve, you’re achieving several goals that Mark Powers describes in Starting Out In Futures Trading (Probus Publishing). By checking out the yield curve, you can
Focus on the cash markets. Doing so enables you to put activity in the futures markets in perspective and provides clues to the relationships among prices in the futures markets.
Watch for prices rising or falling below the yield curve, indications that can be good opportunities to buy or sell a security.
Know that prices above the yield curve point to a relatively underpriced market.
Know that prices below the curve point to a relatively overpriced market.
Getting the Ground Rules of Interest-Rate Trading
Interest-rate futures serve one major function. They enable large institutions to neutralize or manage their price risks.
As an investor or speculator who trades interest-rate futures, you look at the markets differently than banks and other commercial borrowers. The interest-rate market is a way for them to hedge their risk, but for you, it’s a way to make money based on the system’s inefficiencies, which often are created by the current relationships among large hedgers, the Fed, and other major players, such as foreign governments.
A perfect example of an inefficient market is when a large corporation wants to sell a big bundle of bonds but can’t seem to find buyers. When this happens, the corporation is forced to offer a higher yield for its paper. This situation can spread into the treasury markets, as the lack of interest for the corporate offering raises the yields on the corporate bond package. At some point the yield may become attractive enough to attract buyers. Yet, in some instances treasury prices may fall and yields rise as some players sell treasury bonds to raise money to buy the corporate bonds because they offer a higher interest rate.
That kind of situation arises occasionally and can create volatility in both the corporate and treasury bond markets. Sometimes, these short-term gyrations can offer entry points into the treasury futures bond market on the long or the short side, depending, of course, on the prevailing market and the price trends at the time.
Generally, you want to watch for the following:
Opportunities to trade the long-term issues when interest rates are falling
Opportunities to sell bonds short when the prevailing tone is toward higher interest rates
Nevertheless, regardless of rules or general tendencies of markets, focusing on what’s happening at the moment and trading what you see are important guidelines to follow.
When getting ready to trade, make sure that you do the following:
Calculate your margin requirements. Doing so enables you to know how much of a cushion for potential losses you have available before you get a margin call and are required to put up more money to keep a position open. Never put yourself in a position to receive a margin call.
Price in how much of your account’s equity you plan to risk before you make your trade.
Canvass your charts so that you know support and resistance levels on each of the markets that you plan to trade, and then you can set your entry points above or below those levels, depending, of course, on which way the market breaks.
Be ready for trend reversals. Although you need to trade with the trend, you also must be ready for reversals, especially when the market appears to be comfortable with its current trend.
Understand what the economic calendar has in store on any given day. Knowing the potential for economic indicators of the day to move the market in either direction prepares you for the major volatility that can occur on the day they’re released.
Pick your entry and exit points, including your worst-loss scenario — the possibility of taking a margin call.
Decide what your options are if your trade goes well and you have a significant profit to deal with.
Playing the Short End of the Curve: Eurodollars & T-Bills
When you trade the short end of the curve, you’re using Eurodollars, T-bills, LIBOR, or short-term Eurobond futures as your trading vehicle.
Eurodollar basics
A Eurodollar is a dollar-denominated deposit held in a non-U.S. bank. A Eurodollar contract gives you control of $1 million Eurodollars and is a reflection of the LIBOR rate for a three-month, $1-million offshore deposit. Eurodollars are popular trading instruments that have been around since 1981. Following are some facts about Eurodollars that you need to know:
A tick is the unit of movement for all futures contracts, but in the case of Eurodollars, a point = one tick = 0.1 = $25. If you own a Eurodollar contract, and it falls or rises four ticks, or 0.4, you either lose or gain $100, respectively. Eurodollars can trade in 1/4 or 1/2 points, which are worth $6.25 and $12.50, respectively.
Eurodollar prices are a central rate in global business and are quoted in terms of an index. For example, if the price on the futures contract is $9,200, the yield is 8 percent.
Eurodollars trade on the CME with contract listings in March, June, September, and December. Different Eurodollar futures contracts suit different time frames. Some enable you to trade more than two years from the current date. This kind of long-term betting on short-term interest rates is rare, but sometimes large corporations use it. For full details, it’s always good to check with your broker about which contracts are available, or go to the CME Web site.
Trading hours for Eurodollars are from 7:20 a.m. to 2:00 p.m. central time on the trading floor, but they can be traded almost 24/7 on Globex, the electronic trading home of a large variety of futures contracts. For Eurodollars, Globex is shut down only between 4 and 5 p.m. nightly.
The initial maintenance margins for trading Eurodollars in March 2008 would be $1,013 and $750, respectively.
Trading Eurodollars
Eurodollars are the most popular futures trading contract in the world, because they offer reasonably low margins and the potential for fairly good return in a short period of time.
You want to trade Eurodollars when events are occurring that are likely to influence interest rates. If you grasp the concept of trading Eurodollars, you’re also set to trade other types of interest-rate futures, as long as you understand that each individual contract is going to have its own special quirks and idiosyncrasies. The CME has an excellent education section on its Web site at www.cme.com/edu/.
If you trade interest-rate futures, here are some basic factors to keep in mind:
Check the overall trend of the market.
Consider whether the market is oversold or overbought.
Decide how much you’re willing to risk before you enter the trade.
Look at the overall background for the trade you’re going to execute before doing so.
Picking your spot to trade
A good opportunity for trading Eurodollars futures was the week ending July 1, 2005, when the economic calendar was heavy in terms of the number of releases and their importance regarding what the Fed was likely to do next with interest rates. Included on the calendar, the Fed had a two-day meeting scheduled at which it was widely expected to raise interest rates.
Aside from the Fed’s announcement on interest rates the afternoon of June 30, the economic calendar featured two particularly tradable reports on July 1: the University of Michigan Consumer Sentiment Index and the Institute for Supply Management (ISM — purchasing manager’s) report. Each is a key barometer of activity for a major cog in the economic food chain.
The Fed raised interest rates on June 30 and told the markets that they could expect them to be raising rates again in the future. Economic reports all showed signs of a strengthening economy. And the markets were poised for such a set of developments.
Figure 10-3 shows three months’ worth of trading in the July 2005 Eurodollar contract. Note that the price break below the moving average on the far right, correctly predicted a fall in prices. Also note the overall downtrend in the Eurodollar during the three-month period, which is a sign of rising interest rates. The implied (interest) rate for this contract at the close on July 1 was 3.6175 percent, up from 3.40 in May. You can calculate the implied rate by subtracting the contract price from 100, as described in the earlier “Globalizing the markets” section.
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Figure 10-3: A chart of the Eurodollar’s July 2005 contract illustrates a good opportunity to sell short and how to calculate implied contract interest rates based on prices. |
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Managing your trade
Assume for a moment that you shorted one contract when the price slipped below the four-day moving average on June 27 so that your order was filled at the close of the regular session at 9642. To protect yourself and cover your short position, you put a buy stop five ticks above the moving average, at 9647, thus limiting your loss to $125 above the crossover price. Thereafter, you adjust the stop on a daily basis to protect your gains based on your risk tolerance. In this example, I use broad numbers, but you need to set your stop in a way that you don’t risk a margin call if the trade goes against you. In other words, in this trade, your losses need to be limited to no more than $245 (roughly a ten-tick loss), because a $245 loss will get you a margin call if all you have to start with is the minimum margin of $945 (your account equity would have dropped to $700).
Setting your stop a good distance from the margin call is a good idea, though, to allow some leeway in case the market moves fast against you. The more room between your stop and the margin call, the better off you are. The more you trade, the more you’ll develop a sense of what your risk tolerance is.
As a general rule, you should never risk any more than 5 percent of your equity on any one trade with a small account. The bare minimum requirement for trading futures as an individual small speculator is widely accepted to be no less than $20,000, although $5,000–10,000 may be good enough if you’re very good at managing your risk and develop a keen sense of timing and discipline. See Chapters 17, 18, and 19 to review trading plans and strategies.
By the close of trading July 1, after a five-day holding period, the gain on the hypothetical trade was $93.75. A good move then would have been to move your stop down to 9642 so that a gain would not turn into a loss if the market turned against you. You should also continue to change your stop as the market continues to gain roughly in equal increments to the gains that you’re getting from the trade.
If you happened to be short, or betting on falling Eurodollar prices, like in the example, a fall of this size would make you a good profit, as long as you continued to trade with the overall trend and continued to adjust your stop. If you were long, or betting on higher prices, you’d lose. In a small account, even a $250 loss could be significant, but if you used good risk-management techniques, such as a trailing stop like the one described in the example that accompanies Figure 10-3, you wouldn’t let the Eurodollar contract move against you that far. See Chapter 17 for more about trading plans.
At this point, the example trade has earned a nice profit of 3.75 ticks, or $93.75 per contract over five days. Your account started at $945 and rose to $1,038.75. So right before a three-day July 4th holiday weekend, when the Group of Eight was meeting in London with large numbers of demonstrators present and a nine-country rock concert was planned to raise awareness for the famine in Africa, you could have
Closed the position and taken your profits, less commissions.
Tightened your short covering stop by setting it at 9641.05, just above the closing price (9640.0625); refer to Figure 10-3.
Sold a portion of your position if you had more than one contract, taking a part of your profits and adjusting the remaining position by tightening your stop.
Considered establishing option strategies. In this case, because you’re short, a call option would be the correct move. A put option would be the correct choice if you were long, because a put option generally rises in price when the market falls. (See Chapter 4 for the basics of options trading.)
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If you do get a margin call, you can
Liquidate your position to meet the call and then take a break for a few days until you get your wits back together.
Sell some of your position to meet the call.
Deposit new money into your account to meet the call.
Trading Treasury-bill futures
A 13-week T-bill contract is considered a risk-free obligation of the U.S. government. In the cash market, T-bills are sold in $10,000 increments, such that if you paid $9,600 for a T-bill in the cash market, an annualized interest rate yield of 4 percent is implied. At the end of the 3 months (13 weeks), you’d get $10,000 in return.
Risk free means that if you buy the T-bills, you’re assured of getting paid by the U.S. government. Trading T-bill futures, on the other hand, is not risk free. Instead, T-bill futures trades essentially are governed by the same sort of risk rules that govern Eurodollar trades. T-bill futures
Are 3-month (13-week) contracts based on $10,000 U.S. Treasury bills.
Have a face value at maturity of $1,000,000.
Move in 1/2-point increments (1/2 point = 0.005 = $12.50) with trading months of March, June, September, and December.
Trading Bonds and Treasury Notes
The 10-year U.S. Treasury note has been the accepted benchmark for long-term interest rates since the United States stopped issuing the long bond (30-year U.S. Treasury bond) in October 2001. Thirty-year bond futures and 30-year T-bonds (issued before 2001) still are actively traded, and the U.S. Treasury issued new 30 year T-bonds in February 2006.
What you’re getting into
Bond and note futures are big-time trading vehicles that move fast. Each tick or price quote, especially when you hold more than one contract and the market is moving fast, can be worth several hundred dollars. Some other facts about 10- and 30-year interest-rate futures that you need to know include that they are
Traded under the symbols TY for pit trading and ZN for electronic trading in the 10-year contract.
Valued at $100,000 per contract, the same as for a 30-year bond contract (which is traded under the symbol US for pit trading and ZB for electronic trading).
Longer-term debt futures that have higher margin requirements than Eurodollars. As of February 2008, the initial margin for 10-year and 30-year note and bond contracts, respectively, were $-1620 and $2295. Maintenance margins, respectively, were $1200 and $1700 per contract.
Quoted in terms of 32nds and that one point is $1,000 and one tick must be at least
• 1/2 of 1/32 or $15.625, for a ten-year issue
• 1/32, or $31.25, for a 30-year issue
When a price quote is “84-16,” it means the price of the contract is 84 and 16/32 for both, and the value is $84,500.
Bonds are traded on the CBOT from 7:20 a.m. to 2:00 p.m. central time Monday through Friday. Electronic trades can be made from 7 a.m. to 4 p.m. central time Sunday through Friday.
Trading in expiring contracts closes at noon central time (Chicago time) on the last trading day, which is the seventh business day before the last business day of the delivery month.
What you get if you take delivery
If you take delivery, your contract is wired to you on the last business day of the delivery month via the Federal Reserve book-entry wire-transfer system. What you get delivered is a series of U.S. Treasury bonds that either cannot be retired for at least 15 years from the first day of the delivery month or that are not callable with a maturity of at least 15 years from the first day of the delivery month. The invoice price, or the amount that you have to tender, equals the futures settlement price multiplied by a conversion factor with accrued interest added. The conversion factor used is the price of the delivered bond ($1 par value) to yield 6 percent.
Bonds that are not callable remain in circulation until full maturity, which means that the holder receives all the interest payments until the bond expires, when the principal is returned. Callable bonds put the holder at risk of receiving less interest because of an earlier retirement of the bond than the holder had planned.
For T-notes, you’d receive a package of U.S. Treasury notes that mature from 61/2 to 10 years from the first day of the delivery month. The price is calculated by using a formula that you can find on the CBOE Web site. As a small speculator, your chances of getting a delivery are nil.
Figures 10-4 and 10-5 show the ten-year U.S. T-note futures for December 2005. Figure 10-4 shows a good example of a moving-average trading system during the same time period featured in the Eurodollar sections earlier.
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Figure 10-4: A trade featuring the U.S. Ten Year note. |
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During the time frame shown in Figure 10-4, even as Eurodollars and short-term instruments fell in price, longer-term instruments rallied because the market continued to believe that higher short-term interest rates eventually would slow down the economy. Elsewhere in the mix were pressures from hedge funds, foreign governments, and big traders setting up huge derivative trades in the options market. The overall effect, however, was to keep long-term interest rates going down and bond prices rising on the long end of the curve.
In June, after the ninth interest rate increase by the Fed, the market decided that the economy was likely to keep strengthening and that the Fed would keep raising rates. According to bond trader rules, rate increases in a strong economy spell a strong sign of inflation and a reason to sell bonds. Other factors that are evident in Figures 10-4 and 10-5 include the following:
T-note futures rose during the period of interest rate increases until the month of June, when the contract began to struggle. In the cash bond market, long-term rates had been falling until the same time period when they became volatile.
The trend was above the trio of moving averages — the 5-day, the 20-day, and the 10-day — much of the time.
An excellent entry point is found in April in Figure 10-4 where the 5-day moving average crosses over the 10-day and the 20-day moving averages. Buying a portion of your position at the first crossover is a common practice when using the moving average crossover as a trading method. You then buy the second portion of the position at the second crossover. You could have bought as the 5-day average crossed over the 10-day average, and again when the 10-day average crossed over the 20-day average.
The uptrend stayed intact until June, so reversing the crossover is just as easy as the chart points out. You can also hedge your position if you’re unsure whether the crossover is temporary or you’re seeing a significant top by buying a put option.
The break below all three moving averages was clear in late June, giving you an opportunity to sell short.
You need to use trailing stops when trading all futures contracts so that even when you aren’t sure whether a top was reached, you nevertheless are stopped out when the price falls below the three moving averages.
Figure 10-5 highlights the use of good trend-line analysis. Take note of the following:
A double top in bond prices and a key break below the rising trend line. Note that when the Fed raised interest rates June 30, bond prices failed to close above the previous day’s intraday high price, a signal that the market was exhausted. Sure enough, it closed significantly lower the next day.
The price on July 1. Closing within the gap is a good example of how gaps become magnets for price reversals at some point in the future.
The 116 support level. Your next indicator to watch is when the market tests the 116 key-support area. If you shorted the break in prices below 118, you’d be looking to cover at least some of your short position by buying the contract back and specifying that you are doing so with intent to cover the short position or buying some call options to hedge your position near that area.
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Figure 10-5: U.S. Key technical aspects of the U.S. Ten Year note in response to an interest-rate increase by the Federal Reserve. |
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