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Bridging Volatility Gaps With Weekly Treasury Options

By Robin Belec, In Touch Capital Markets
December 17, 2012 One problem with trading options and volatility is how to capture financial markets short-term spikes and swings. Economic releases come and go on a steady basis and affect short-term trading more than anything else. On the other hand, relatively few economic or other events are sticky, with lasting impact that sends markets to a different level or results in a paradigm change. At one time, there was a dearth of instruments that could effectively capture this short-term volatility. But thats been remedied by the CME Groups Weekly Options on U.S. Treasury futures, launched in January 2011. Weekly options on the 2-, 5- and 10-year Treasury futures bridge that volatility gap, offering opportunities for investors and market-makers to capture those swings and spikes on a daily basis. Recent political and macroeconomic events have led to dramatic increases in trading volume of these contracts, with an average of 462,557 contracts changing hands each day in November, up 77% from the same month a year earlier. Federal Reserve policy meetings and U.S. economic releases, such as the Labor Departments Employment report, often lead to surges in trading. Since some economic releases sometimes only move the market momentarily, and are thus non sticky, some market participants may prefer to use these short-term options to position themselves for a mean reversion trade. As an example, a call option could be sold if the market rallies on an economic release; If the driver of the rally is non-sticky, then one could wait for the option to expire in few days and pocket the premium.

DelTa HeDGinG
A common problem encountered by many volatility desks is the frequency and time of delta hedging in order to capture the premium paid of an option. This is usually called gamma hedging. Market-makers pay more attention to spontaneous drivers in order to delta-hedge and realize the volatility. This gives

more depth and liquidity to the Treasury futures markets and also introduces some extra volatility. Many investors or asset liability managers do not have the tools or the necessary infrastructure to hedge against adverse movements on interest rates. Until recently, they could only hedge with much longer expirations that did not necessarily match the profile of their portfolio. Similarly, the swings in the market have become more pronounced as we have moved to a zero interest rate environment. A few basis points represent a much bigger percentage of a portfolios delta than before. Weekly Treasury Options capture that volatility and allow the users not only to hedge their portfolios effectively, but also to successfully implement an investment idea based on the economic release calendar.

the-money or within one strike price away of the underlying security level. In many instances this permits market participants to use this property to hedge any underlying gamma position in their own portfolio.

BuilDinG a mOre accuraTe yielD curVe

Building an accurate yield curve especially is a rather technical but very important consequence of Weekly Treasury Options. With weekly options, one can build a microstructure on the yield curve and also expose some arbitrage opportunities that would not be available otherwise. To fully understand the usefulness of Weekly Treasury Options and how they can be used in a trading portfolio, we will review how the contracts could have been applied around the U.S. elections last month and then investigate their usefulness in trading the upcoming effects of the fiscal cliff. As the November 6 elections approached, many market participants believed a couple of things: If President Obama

Gamma HeDGinG
Since all of these short-term options have very large embedded gamma close to maturity, they tend to retain their price value even toward the last day of trading if at-

was re-elected, bond prices would likely rally; If Mitt Romney was elected, bonds would sell off. Since polls indicated a tight race, financial market traders anxiously awaited the election results before CME Treasury futures could price the appropriate outcome. With Obama re-elected, bonds rallied, as expected, while the Republicans retained control of the House of Representatives. The 10-year Treasury note futures rallied from an average of some 132 24/32 before the elections to 134 by the end of the week Correspondingly, the one-week call option with a 133 strike increased from 30/64 to 58/64 during the same period, thereby almost doubling in value and illustrating the advantage of using these contracts to trade short-term market-moving events. While U.S. elections do not disrupt the market on a regular basis, similar analysis can be used for other events that could likely result in re-pricing of Treasury futures. Widely-followed economic reports, such as monthly payrolls, retail sales, and the Consumer Price Index, as well as Fed policy meetings, all have the potential of moving the market significantly. With the Feds announcement last week that it will maintain stimulus measures until the unemployment rate falls to 6.5%, from 7.7% in November, these economic releases should generate even more volatility in market pricing. On the political front, some important upcoming dates include: January 1 Fiscal cliff, a combination of automatic tax increases and spending cuts, takes effect. January 2 Office of Management and Budget begins sequestration January 3 New Congress convenes. January 21 Presidential Inauguration.

February Potential debt-ceiling deadline. March 31 Discretionary spending authority extensions expire.

ScenariO analySiS On THe fiScal cliff :

Both Obama and Republican in Congress appear to have every intention of avoiding the negative economic impact of the fiscal cliff. But so far, party posturing and politics seems to be more important than the welfare of the electorate. With that in mind, here are three potential outcomes and their implications on financial markets: 1) Bipartisan agreement on budget, taxes and the debt ceiling. Although looking more and more unlikely as we approach the January 1 deadline, this scenario could resolve U.S. fiscal difficulties for the long-term. Since the financial market prices a probability of hitting the fiscal cliff, this could provide a short-term relief rally in equities, while bonds would likely sell off. Since an agreement between both parties can occur anytime between now and the beginning of 2013, positioning for this scenario would involve buying short-term puts on

Treasuries whenever a market participant believes it may have become a realistic scenario. 2) Party politics wins over sanity and the fiscal cliff is hit. This scenario could be triggered if Obama vetoes any bill that does not include tax hike on the wealthy or Republicans refuse to sign any bill increasing taxes. That would reverberate through the economy, potentially pushing the U.S. back into recession. Fixed-income prices would rally, helped by the Feds bond purchases, while equities sell off. 3) Three- to six-month budget agreements forestall the fiscal cliff, and there potentially is a small, temporary increase in the debt ceiling. Both sides agree at the last minute for a delay in the automatic implementation of the measures of the fiscal cliff. This would of course provide time for the new Congress to reconvene before serious discussions on the matter of longterm fiscal health of the U.S. government is addressed. Market impact depends on how much political bad blood is created, and both fixed-income and equity markets may tread water until a resolution is reached. For all of these scenarios, investors and traders can use Weekly Treasury Options to position themselves.

To increase the payout ratio of this trade, it could be feasible to enter into a call spread position, whereby the trader buys an at-the-money call option and sells an out-of-the-money call to reduce the cost of entering into the transaction. Buying the one-week at-the-month call for 22/64s and selling a one-week out-of-the-money call (at a strike half a point higher) for 10/64s reduces the cost of entering the position to 12/64s. Although the maximum return for the position has now been capped at 32/64s no matter how high 10-year Treasury futures rally, the profit is nonetheless 20/64s on the position. Robin Belec is Chief Operating Officer for In Touch Capital Markets, a London-based financial markets intelligence provider.

PlayinG THe mOnTHly PayrOllS

In another example, Weekly Treasury Options could be applied to take short-term positions surrounding the monthly employment report. In Touch Capital Markets analysis shows that a miss of about 76,500 in non-farm payrolls typically corresponds to the 10-year Treasury future moving roughly 49 ticks (almost 16/32). For someone who believes market expectations are off by 100,000 jobs or so, taking a position with a weekly 10-year option can be a winning trade. In this example, the cost of a one-week option is about 22/64s. A negative surprise of 100,000 would likely result in a rally of some 41/64s in 10-year Treasury futures, resulting in a profit of some 19/64s on the trade.
This information was obtained from sources believed to be reliable, but we do not guarantee its accuracy. Neither the information nor any opinion expressed therein constitutes a solicitation of the purchase or sale of any futures or options contracts.

Weekly Op ons on U.S. Treasury Futures Contract Specica ons

Underlying Unit One 2-Year, 5-Year, 10-Year, T-Bond or Ultra T-Bond futures contract of a specied delivery month. 2-Year Tick Size 5-Year 10-Year, T-Bond and Ultra T-Bond 2-Year Strike Prices 5-Year and 10-Year T-Bond and Ultra T-Bond Week 1 Week 2 Expira on Dates** Week 3 Week 4 Week 5 Last Trading Day one-half of 1/64th of a point ($15.625)* one-half of 1/64th of a point ($7.8125) 1/64th of a point ($15.625) one-quarter of one point one-half of one point one point 1st Friday of the month 2nd Friday of the month 3rd Friday of the month 4th Friday of the month 5th Friday of the month

A given Friday that is not also the last trading day of a monthly serial or quarterly Treasury op on. If such a Friday is the last trading day of a monthly serial or quarterly Treasury op on, there will be no Weekly Treasury op on listed for trading for that expira on date . American-style. The buyer of an op on may exercise the op on on any business day prior to expira on by giving no ce to CME Clearing by 6:00 p.m. , CT. Op ons that expire in-the-money on the last trading day are automa cally exercised, unless specic instruc ons are given to CME Clearing. Unexercised op ons shall expire at 7:00 p.m. CT on the last trading day Open Outcry CME Globex 2-Year 5-Year Mon-Fri: 7:20 a.m. - 2:00 p.m., CT Sun-Fri: 5:30 p.m. - 4:00 p.m., CT Open Outcry: TW1-5 Open Outcry: FV1-5 Open Outcry: TY1-5 Open Outcry: US1-5 Open Outcry: UL1-5 CME Globex: ZT1-5 CME Globex: ZF1-5 CME Globex: ZN1-5 CME Globex: ZB1-5 CME Globex: UB1-5

Exercise

Expira on Trading Hours

Ticker Symbols

10-Year T-Bond Ultra T-Bond

*no onal size of underlying 2-Year T-Note futures is $200,000 vs. $100,000 for all other Treasury futures contracts **A WTO will not be listed to expire on the Friday of the standard serial or quarterly Treasury Op ons
Copyright 2010. CME Group. All rights reserved. CME Group, the Globe Logo, Globex and CME are trademarks of Chicago Mercan le Exchange Inc. CBOT is the trademark of the Board of Trade of the City of Chicago. NYMEX is trademark of New York Mercan le Exchange, Inc. The CME Rulebook and/or CBOT Rulebook should be consulted as the authorita ve source on all current contract specica ons.