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Bond Market Fundamentals Dec2012
Bond Market Fundamentals Dec2012
GETTING STARTED
IN
BOND
MARKET
FUTURES
GUY BOWER
The Guide For the Active Day Trader
Contents
Part 1: The Basics
A.
B.
C.
D.
Introduction
What Are DV01s And Why Do You Need Them?
Trading Example 1: US Yield Curve
Trading Example 2: Au:US 10s:10s Spread
Trading Example 3: The 10s Overreact On Open
Hedge Ratios
Summary
Executing Spreads
Charting Spreads
When is a Spread Not a Spread
Some Spread Research Ideas
The Laggard
The DV01 Gapper
Yield Curve High Jinx 5, 10, 30 example
Last to go (data)
Other setups
More Information
About The Author and Contact Details
Assumed Knowledge:
Mechanics of futures contracts.
A very basic definition of spread trading.
A very basic understanding of market depth.
Introduction
There must be hundreds of books out there that suggest they will show you how to trade a
certain market with specific tools then simply end up showing how to read a chart or spot a
breakout. That is the generic market analysis that has been around for years and years.
At Propex, we set out to write this guide with the goal of NOT pumping out something
people have read before. This guide is specifically designed for our trainee bond futures
traders. It is also applicable to anyone else interested in bond markets.
It covers topics that are specific to trading bonds. We are not covering the hardcore maths
so much, but covering things such as yield analysis (instead of just price analysis) and other
factors specific to the Australian and US fixed interest futures markets.
All in all, they are great markets to trade and offer some fantastic opportunity when traded
together.
It should also be noted that we use the term bond throughout this lesson as a generic term
for fixed interest futures that includes both notes and bonds. Same, same unless otherwise
stated.
So, What is a Bond?
A government raises money in two ways: taxes and borrowings. Borrowings are in the form
of bills (short dated), notes (short to medium dated) and bonds (long dated).
In most developed economies, a futures exchange will make contracts available based on
the active and available securities issued by the government.
Lesser developed countries are less likely to have a significant long dated securities market
given the sovereign risk. Alternatively, more developed economies will have a spread of
securities.
In Australia, there are 3yr bonds and 10yr bonds (plus bank bills and the cash rate futures).
In the US, given it is a more developed bond market, there is everything from the Fed Funds
rate out to the ultra bond, a 25yr+ futures contract. The key markets in the US, and the
ones we will look at here, are the 5yr note, 10yr Tnote and the T-bond. In most developed
markets, the 10yr bond is the benchmark security.
The basic structure is that the investor gives the government $100 and the government then
gives the investor a piece of paper that says it will pay $6 (6% of $100) for the life of the
bond plus the $100 back at maturity. Note, that percentage, called the coupon is fixed for
the life of the bond.
That transaction is conducted in what is called the primary market. There is also a secondary
market - a market in which the investor can sell their bond to someone else. Naturally, it
makes sense to be able to sell the bond if the holder doesnt want to keep it for the whole
10yrs.
If over the whole 10 years, interest rates remain at 6%, then the value of the bond will
remain constant and the pricing of this bond is pretty straight forward. However, interest
rates can and do change on a daily basis.
If interest rates rise to say 7%, new investors will be able to lend to the government for 7%
and would have no interest in buying a bond paying only $6 IF the price of the bond remains
the same.
It is not only the price of the bond that varies, the effective yield received from the bond
paying $6 also varies. Thats the important bit.
If we fast forward the above example by one day and for whatever reason interest rates
have increased by around 50 basis points. That means a 10yr bond should be paying around
6.50%.
Naturally, a new investor would rather buy a bond paying $6.50 per annum than one paying
$6.00. If the owner wanted to sell the 6% bond in the secondary market they would have to
adjust the price to make the $6 payment equivalent to a 6.50% return on the amount paid.
Would the price of the bond have to go up from $100 or down? If it went up, the effective
return would be even less in terms of percentage of the amount paid. If the price went
down, that effective yield would increase.
What if the price was $50 instead of $100? Excluding the effects of time (its only been one
day) $50 to earn $6 per annum plus $100 at maturity is a very good yield. Using a bond
pricing formula, it would be close to 16.5%.
The bond pricing formula by the way is not worth discussing here. Financial calculators have
the pricing function. If now, youll find one with a quick search on Google
Getting back to our example, lets look at the price of the bond as rates go from 6% to 6.5%.
Again, plugging the numbers into the bond pricing formula and assuming interest is paid
semi-annually (as it is for most bonds) we have a price of $96.37.
So that means that a bond paying 6% per annum (paid semi-annually) and priced at $96.37
is the same as a bond paying 6.5%pa and priced at $100.
This outcome shows you WHY prices fall when rates rise. It allows one bond to be
comparable to another. With most bonds on issue there are only two things that can
possibly change. One is the passing of time (unfortunately unavoidable) and the other is the
bond price. It is the price of the bond that is the variable in the secondary market.
So to further illustrate the inverse relationship, lets calculate some prices given a change in
yield for a $100 par value bond paying 6% per annum, paid semi-annually.
These numbers were calculated using a bond pricing formula found through a Google
search. You dont need to understand the formula to understand the relationship.
Just to illustrate the point, using a bond pricing calculator found online, a price of 110-00
would mean a yield of 4.73%.
http://www.asx.com.au/products/asx-interest-rate-futures-and-options.htm
The following table summarises the values at the time of writing:
Market
Tick size
Tick value
Example
3yrs
0.01 (a full basis point)
$30.58
A move from 97.63 to 97.64 is
worth $30.58.
10yrs
0.005 (half a basis point)
$49.33
A move from 97.01 to 97.015 is
worth $49.33.
Note, in the 10yrs some talk about a tick being a full basis point (0.01) and then refer to a
0.005 move as a half tick. Others, and this is the correct way to do it, refer to the smallest
possible move (0.005) as a tick. Its just something to be aware of.
US Treasuries
The CBOT futures contracts (the 5yr note, the 10yr note and the bond) are all valued at
$1000 per big figure. That is, a move from 120-00 to 121-00 is worth $1000. However, like
the Aussie bonds, the tick size for each contract is different.
First of all, just to confuse the issue, US Treasuries do not trade in decimals. Rather, they
trade in 32nds and fractions thereof. That move from 120-00 to 121-00 is a move of
32/32nds.
The following table summarises the tick values:
Market
Big Figure value
Tick size
Tick value
5yr Note
$1000
One quarter of
1/32
$1000/32/4 =
$7.8125
10yr Note
$1000
One half of 1/32
The T-bond
$1000
1/32
$1000/32/2 = $15.625
$1000/32 = $31.25
This next point is confusing at first, but it makes sense once you think about it. The 10yr
note does not trade in 64ths.They trade in half 32nds. The 5yr note does not trade in
128ths. They trade in quarter 32nds.
Whats the difference you say? Well of course in dollar terms its the same thing, but they
are quoted as 32nds (and fractions thereof) so its easier to make a side by side comparison.
A whole 32nd move in each of the contracts is the same dollar value ($31.25) but it takes the
5yrs four ticks to get there; the 10yrs two ticks to get there and the Tbond just one. So lets
add a tick value example to the table:
Market
Big Figure value
Tick size
Tick value
5yr Note
$1000
One quarter of 1/32
$1000/32/4 =
$7.8125
10yr Note
$1000
One half of 1/32
$1000/32/2 =
$15.625
The T-bond
$1000
1/32
$1000/32 =
$31.25
Example
A move from
124-155 to 124-157
is worth $7.8125.
A move from
133-00 to 133-00
is worth $15.625.
A move from
147-20 to 147-21
is worth $31.25
Note, most systems remove the decimal place so that 124-115 shows up as 124155. Its just
something to get used to. Others use a dash instead of a decimal point or an asterisks or
apostrophe.
Most systems also drop the last digit for a quarter tick in the 5yrs. So its 124157 instead of
1241575 (too many numbers!).
So lets see how these things look on the depth display:
Overall, bond pricing is a little trickier than pricing for shares or other futures contracts, but
it just requires some basic knowledge.
This is a bit of a sideways move from the discussion so far, but it is a need to know topic if you are
looking at more than one bond market (and you should be!).
Naturally, it is the change in the yield curve that concerns us. In most cases a move in the curve will
be a change in the slope of the curve.
Terms to know:
Short end of the curve securities with short dated maturities.
Long end of the curve securities with long dated maturities.
The belly not quite short end, not quite long end, right in the middle.
Bear Steepener this is where rates are rising (prices falling) and long end rates are rising faster
than short end rates.
Flatteners are where the difference between the long end and short ends decreases. The terms
bullish or bearish refer to the direction of prices.
Yields fall = bullish = lower rates
Yields rise = bearish = higher rates
Bull Flattener is when yields are falling (prices rising) and the long end is moving further than the
short.
Bear Flattener is when yields are rallying (prices falling) and the short end is falling harder than the
long end.
Inflation. The yield curve will be steep when expectations for short-term inflation are low.
Expectations of strong inflationary pressures will flatten the yield curve.
Monetary Policy. The yield curve will steepen when the Central Bank moves towards a loose
monetary policy. The curve will flatten and can gradually move inverted when policy is tightened.
Operation Twist in 2011 was a good example of the US Feds policy changing the yield curve. In
September the Fed announced they would sell short term bonds and buy long term bonds in an
effort to reduce longer term rates. The effect of such a policy is to flatten the curve by increasing
short term rates and reducing long term rates.
The curve trade to make in this scenario would to be to get long the 30yr bond and spread off with
shorter term notes such as the 2yrs. In two days the long end rallied over 5 handles whereas the
short end hardly moved (nobody expected much of a change in short end rates given the Feds
commitment to keeping short end rates low).
Supply of and Demand for Treasury Bonds. Activity in treasury financing (supply) and large managed
funds (demand) can also have an effect on the yield curve. Specifically, supply or demand constraints
in particular maturities can lead to changes in the relative prices of certain points along the curve.
Here we will continue to look at the US Treasuries the 5yr Tnote, the 10yr Tnote and the 30yr
bond. We will also look at the Australian bonds the SFE 3yr and 10yr bonds.
For most readers, I expect the concept of a DV01 to be new and of course we will ask if it is worth
learning? The answer is pretty simply yes, it is worth learning. The concept itself is relatively
simple; the data is easy to find, and more importantly, it helps to find good trades. Nuff said!
That is, prices are inverse to yield, but what is the exact relationship? If we are going to look at
trading these markets together, we need to know how they relate.
Thats what DV01s tells us. It is the dollar value change in price of the fixed interest security given a
fixed one basis point change in yield.
Aussie Bond DV01s
The ASX(SFE) bond futures are quoted:
Price = 100 - yield
Therefore the DV01 is simply the same as the value of a 0.01 move. Currently, these are:
Contract
AU 3s:
DV01 in AUD
$30.58
DV01s in USD
$31.50
AU 10s:
$96.66
$99.56
The pricing convention for Aussie bond futures is similar to most short-term interest rate futures
around the world such as Eurodollar and Euribor. Therefore the DV01 for these short term securities
is also simply the tick value for a $100,000 equivalent (the face value of the bond contract).
Given the way the 3yrs and 10yrs are priced, the DV01 changes as the price changes, albeit in small
increments. The SFE have made available an excel template to calculate the numbers. Download it
here:
http://guybower.com/?p=1840
US Treasuries
Its a little harder to calculate DV01s for Treasuries given they are quoted in price not yield.
Calculating DV01s from scratch requires the use of the bond pricing formula. The easier way is to
look them up. See this link for more information:
http://guybower.com/?p=1840
Currently we have:
Contract
5yr Tnote:
10yr Tnote:
30yr Tbond:
DV01
$51.05
$78.30
$166.52
32nds
1.63
2.51
5.33
Tick Increment
Quarter 32nds
Half 32nds
Whole 32nds
Approx Ticks
7 quarter 32nds
5 half 32nds
5/32nds
Note, the 2yr Tnote has been left out of this table given its different contract value.
These numbers essentially show the change in price of the respective bond futures contract given a
1 basis point shift in the yield curve.
This is an interesting table to analyze. It essentially tells us how far each contract will move given a 1
basis point change in yield. In other words it tells us how far market A should move if market B
moves by X amount.
The US Treasuries trade in 32nds and fractions thereof. This in itself can make relative value analysis
a little confusing. However if we starting thinking in 32nds, we can have a rule of thumb idea on how
much one market should move given a move in another.
Naturally, this assumes that the two or more securities will move by the same number of basis
points. If this were a 100% valid assumption, there would be no trading opportunity. However, this
assumption is where we start with our analysis. Its used as a point of comparison.
So with the DV01s in hand, lets go through a few examples.
Then:
DV01(30yrs) = 166.52
1/32nd = $31.25 tick value
DV01(10yrs) = 78.30
1/32nd = $31.25 tick value
Then:
1.88 basis points equals 1.88 * 78.30/31.25 ticks. Thats 4.70 32nds. In practice that is between 4.5
and 5 32nds.
5yrs - Given:
DV01(5yrs) = 51.05
1/32nd = $31.25 tick value
Then:
1.88 basis points equals 1.88 * 51.05/31.25 ticks. Thats 3.065 32nds. In practice that is between 3
and 3.25 32nds.
So a move of 10/32nds in the Tbond should see a move of around 3/32nds in the 5s and 5/32nds in
the 10s.
If we see a scenario where this is not happening, there is opportunity. Consider this:
Contract
DV01
32nds
Change
5yr Tnote:
10yr Tnote:
30yr Tbond:
$51.05
$78.30
$166.52
1.63
2.51
5.33
+3/32
+4.5/32
+16/32
Approx Change in
Yield
-1.84bps
-1.80bps
-3.00bps
If we see those changes in price for the three treasuries, we have quite different changes in yield.
The 5s and the 10s changed by less than 2 basis points where as the Tbond change by 3 basis points.
Has the Tbond moved too far or have the 5s and 10s moved too little? Its hard to say. Perhaps the
trade to make is to be long both 5s and 10s and short the Tbond. This would benefit from
realignment on the yields.
The Rule of Thumb
Use DV01s as a rule of thumb for how much a market should move given a move in a closely related
market.
From the numbers above, one basis point in each security works out to be:
Contract
5yr Tnote:
DV01
$51.05
32nds
1.63
10yr Tnote:
30yr Tbond:
$78.30
$166.52
2.51
5.33
So a move of 2.5 32nds in the 10s should see a move of around 1.5-1.75 32nds in the 5s and around
5 32nds in the Tbond.
This rule of thumb is the starting point for your analysis. Naturally it does not factor in changes in the
slope of the yield curve, driven perhaps by some unexpected news or data release. It is simply the
place to start.
Pick any period chart (the above is daily) and youll see the two are highly correlated. The question
we must ask however is how can we spot the trading opportunity? The answer lies in using .DV01s.
Given the two contracts are priced differently the way to compare them is by applying the DV01
calculation.
Contract
US 10yrs:
DV01
US$78.30
1bp =
2.51 32nds
AU 10yrs:
AU$99.56
0.01
What this table tells us is that if the Aussie market is going to follow the US, then a move of 2.5
32nds in the Tnote will be equaled with a one tick move in the 10yrs. This is quite interesting and
very applicable.
Lets say we have a scenario where before the Aussie market open, we see the 10yr Tnote on Globex
trade 20 32nds higher. Naturally we would expect the Aussie 10s to open higher, but how much
higher?
If we make the assumption that the Aussie market will follow the US, a 20 tick move in the Tnote
should see an 8 tick move in the Au 10s:
20 32nds = approximately 8 basis points (20/2.51)
Thats a pretty simple calculation and interestingly the assumption that yields will move together will
often hold true but not all the time. It is at those times where we see a divergence that the trading
opportunities present themselves.
If, for example we say the Au 10s open 4 ticks higher, not 8; in most situations, that would be a
pretty low risk buy.
Tightening up on risk, you could even sell the Tnote at the same time as buying the Aussie 10s and
thereby create a spread. While there is no reason the US market will take a lead from the Aussie
markets, a quick reversal in the Tnote could mean you can cover your Aussie 10s with little impact
and make a little on the Tnote. Rather than think of the 10:10 as a spread, think of the Tnote as
temporary insurance against the long Aussie position.
Now, we know a 2.5/32nd move in the Tnote is equivalent to a 0.01 move in the Aussie bonds, so
youd expect a reopen around 96.710-715.
Interestingly, the market re-opened at 96.705 and immediately traded down to 96.675. There was
no other news and the Tnote did not continue lower.
The trade to make here would be to buy all the way down to 96.675 with a very short term outlook
for upside. As you can see on the chart the market came back within minutes offering up a few ticks
in profit.
Interestingly, the Aussie market again made a dip lower shortly thereafter. (See the circled areas on
the charts.) Note how the Aussie market made a new low that was not matched by the Tnote. That is
another high probability long Au bond trade worth a few ticks.
Spread Anyone?
So should these long Au bond trades have been spread-off with the US Tnote? The answer is maybe.
In this example spreading/hedging would have worked well, but being long the Au 10s was also a
good trade. There are times when it pays to spread against the US, but there are plenty of other
opportunities where we just see the Au 10s playing catch up or coming back from an over-reaction.
In these scenarios, the simpler trade is not to spread.
Should We Look at Other Markets?
During the Sydney winter (non-daylight savings), the European markets get into the swing at 16:00
Sydney time. That is 30 minutes before the Au day session close. This means their opening market
volatility can translate to volatility on the close/re-open in the Sydney markets. More often than not,
a certain move in Europe will also be seen in the US Treasuries, so watching the US is OK. However,
there are times when specific levels might be broken or tested in the European markets and as such
can have implications in the Sydney market.
During Sydneys summer, the Euro markets get into action at 18:00 Sydney time. That is after the reopen. Its worth watching the European open for potential turning points in the Sydney market
around this time.
DV01
US 10yrs:
78.30
Approximate
ratio
2
US 30yrs:
166.52
This is a simple ratio to calculate. The DV01 for the 10s is about half that of the 30s. Therefore to
have the same dollar impact given a fixed change in yield, we would trade 2 10yrs for every 1 30yr.
The exact ratio is not quite 2:1 but its close.
Is this a perfect hedge?
Absolutely not. Think of it as a starting point. If we are looking at a yield curve spread for example
the 10s:30s, then a perfect ratio would assume an equal move in yield. In yield curve talk this is
known as a parallel shift. For smaller movements, this may hold true, but for movement driven by
fundamental shifts in economic conditions (hence interest rate cycles), the change in the yield curve
will rarely be parallel.
With this in mind, trading a spread will most often be a directional position of sorts. However this is
the whole point of spreading as least from a speculative point of view. A perfect hedge means zero
profit potential and zero movement in the spread. We want movement in the spread.
Next is a chart showing both the 30yr Tbond and the 10yr Tnote on the same price scale.
If you look closely, you can see them moving in the same direction at the same time. Thats to be
expected. What is easy to see on the chart is that the Tbond, the one on top, is far more volatile.
That is to be expected given DV01s. A one basis point shift in yield sees a bigger impact in the Tbond.
Now is all that hedged out with a 2:1 ratio? Not quite. Take a look at the next few charts. They show
the dollar values of being in the spread at different ratios. Lets look at the price movement from the
last month or so.
The first chart shows a 2:1 spread (long 10s and short 30s). As prices fell overall, a 2:1 ratio spread
widened, essentially showing a profit. If we were looking for a hedge, it would mean a 2:1 spread
would have been underweight in the 10s.
The next chart shows a 3:1 spread. The value in the most recent month narrowed, or fell, signifying
we were long too many 10s.
The correct ratio was closer to 5:2 (2.5:1). By correct ratio we mean the amounts at which the net
result on P&L would be near zero. That is a hedge. Anything else is a directional position.
So what is the point of all of this? Essentially it demonstrates that yields do not move point for point
across the yield curve. We knew that, but its useful to see how it plays out with real prices.
For the speculator, it means we have to take note of the effect of direction in the underlying market
when placing a certain spread. In practice, traders will adjust the ratio of a spread to suit their view
on direction overall. Makes sense.
The discussion of hedge ratios is a bit of a tangent from the relative value topic, but before putting a
spread on, we need to have an idea of what the spread will do in certain circumstances and the
answer for that is different for different ratios. DV01 calculations are the place to start when looking
at hedge ratios.
3G. Summary
Hopefully the examples of trades showing DV01s in action is enough to demonstrate the power of
understanding DV01s. We use DV01s to better analyse movement in bond prices on a relative basis.
If we are trading one market and looking only at one market, you could argue DV01s are not
important.
Once we start looking at more than one market (and who doesnt?), then the DV01 analysis
becomes quite important.
As previously mentioned, those new to bond trading may not have heard about DV01s. Ironically,
the numbers are easy enough to get and applying the rules of thumb is not that hard. If it means
finding good trades, then why would you not use it?
Wouldnt it be easy if every contract we look at is traded in the same currency and quoted the same
way? Unfortunately they are not. So to chart these spreads, we have to make a few calculations.
The easiest way to chart these spreads is to bring them back to yield. CQG has a function where it
can turn a fixed interest security price into a yield chart. From there, we simply calculate the spread
price and chart.
So to chart any of the US Treasury spreads for example, the following codes would be used:
US Spreads
2s/5s
2s/10s
5s/10s
5s/30s
10s/30s
Code
TUA-FVA
TUA-TYA
FVA-TYA
FVA-USA
TYA-USA
Nickname
"Tuf" Spread
"Tut" Spread
"Fight" Spread
"Fob" Spread
"Nob" Spread
Then right click the title bar, select More, then Yieldas the above image shows.
The same goes for the US-Aussie spreads. We do not need to convert the currency of one to the
other as we already did this when calculating the hedge ratios earlier. With the yield function on
CQG, it is comparing apples with apples.
The codes are:
Aussie Spread
Code
3rs-10yr
HTS-HXS
US - Aussie Spread
10yrs
TYA-HXS
Nickname
"3s, 10s"
"10,10s"
Note, this method of charting looks at the futures yields, not cash note/bond yields. There is often a
difference between futures and cash (known as basis).
Filtering Data
When trading a cross-border spread, it can be useful to filter the display to show only certain trading
hours. You might do this if you are trading the US-Au spreads during the night session only.
SHARESCALE((TUA?1/DV01-FVA?1/DV01),EDA)
2s/10s
5s/10s
5s/30s
The market then falls away, down to 142-00 before Ted decides to act. Rather than stopping out the
trade and admitting the trade was simply a bad one, Ted sells some 10yr notes against it, thinking he
will spread it off and watch it come back (exhibit B).
Think about the logic here. Ted is 26/32nds offside and then enters into a position that will require
the bonds to rally well beyond his original buy price just for that spread to make a decent advance.
Pure logic suggests he has a far better chance of simply holding the outright bonds in anticipation of
a bounce.
Admittedly, the trade would reduce the downside if the market kept falling, but it virtually gives
away any chance of making back the ticks already lost.
As a rough estimate, the bond would have to rally by twice as much as the fall for that spread to
make back the lost ticks.
Turning an outright losing trade into a spread is not a spread strategy.
Admittedly the example above shows a trade that was off side by a large amount before spreading.
However, exactly the same logic applies to smaller moves. Spreading something off makes it harder
for you to make money.
2. Bad Correlations A spread involves opposing positions in correlated markets and the
same positions in inversely correlated markets.
Most of the time, stocks and bonds are inversely correlated. It is not unprecedented for a trader to
spread these markets, perhaps trading relative values or extremes in one versus another.
So what does a spread in say the S&P versus the Tnote look like? Are you long one and short the
other? If you think about it, that is a double directional trade. If they are inversely correlated (stocks
go up bonds go down), then being long one and short the other is taking an even bigger directional
position that you would be trading just one of the markets outright.
The correct spread trade to make in inversely correlated markets is to be long both or short both.
That is a spread.
3. Bad Ratios
If we look at the Aussie 3s:10s spread as being a 3:1 ratio, then are you spreading when you are long
30 threes and short 30 tens?
The answer is yes and no. One way to look at it is you have a spread of 30 threes and 10 tens PLUS
another 20 tens. You are essentially overweight in one leg of the trade and therefore adding a
directional bias.
There is nothing wrong with doing this if it fits into your view, but its not a simple spread trade in
the strict definition. Placing these trades requires a directional view as well as a relative value or
spread view. In many cases you may simply be better off placing a smaller directional trade.
As with other setups here, this setup was not suggesting we were in for a large move. It provided a
very low risk trade good for a couple of ticks. Given the large ticks size in the Aussie bonds however,
a few ticks is a good trade
Market A
95.00
Market B
91.00
Now suppose over the next hour, while Market B is closed, Market A rallies 30pts just ahead of the
Market B reopening. We would then have:
Time
Close
60 mins later
Market A
95.00
95.30
Market B
91.00
?
Market B is about to re-open. Where would you expect it to open. Given its 2:1 correlation, you
would expect it to open around 91.15, 15pts higher.
Excluding any other influential factors, the trade to make would be buying an open up to 91.14 or
selling an open 91.16 or above.
That margin (i.e. one tick below and one tick above, in this case) will vary from market to market and
in different trading conditions, but you get the idea.
So how do we do this in notes and bonds? Aussie and US markets are quoted differently, so we can
use prices only a rough estimate. A more accurate measure is to use DV01 or basis points.
Example:
At the time of the Aussie close, we have the following prices:
Time
Close
DecTnote
133-315
Market B
97.02
While the Aussie market was closed we see the Tnote trade lower by 10/32.
Time
Close
At reopen
DecTnote
133-315
133-215
Market B
97.02
?
Now, from previous pages, we know that one basis point in the Tnote is close enough to 2.5/32nds
and one basis point in the Aussie 10s is 0.01. Assuming then the Aussie market will follow the US
market lower on the open, we should see an opening price of 96.98, 4 basis points lower.
There have been many situations where for whatever reason the Aussie market has not followed the
US market basis point for basis point. Excluding a large move in the currency however, the market
can often return to that expected open level pretty quickly.
Essentially the trade is to take a position in the Aussie market on reopen with the expectation that it
will follow the US market in terms of basis points. It is that closing period that can get the two
markets out of line. More often than not, the first few minutes (but sometimes longer) will see
realignment.
Key points with this trade:
More opportunity comes when the markets have been volatile BUT they can still pop up
when things are quiet. It pays to calculate where the markets should reopen every day and
place orders accordingly.
The Aussie bond markets have a 10 minute auction or pre-open where you can
place/cancel orders but not get filled. After calculating your expected open, why not place
orders above and below in the auction? Sometimes that split second blip on open can get
you in and out of a very quick trade.
If we look at the 5yr, 10yr Tnotes and the Tbond, we have markets where everyone watches the
Tbonds and the 10yr note and that 5yr is like the annoying little brother that just follows along.
That said, people dont ignore the 5yr note. There is still a strong correlation between it and the rest
of the curve, both from click traders and algorithms/autospreaders.
This is the key to the setup: there are times when the 5yr can trigger movement in the others. The
best trades come from this when the market is vulnerable to a certain move such as stops going off
above a high or below a low.
The specific example I have seen played out a few times now is when all three markets were trading
near their intraday highs and the 5yr note went offer over the high while the other two were within
a few ticks off the equivalent high.
One trade to make is to get long the Tbond (having a large tick size) and then use the 5yr note to
make a new high and see if it triggers a move in the bond.
The 5yr note has a small tick size of $7.815. This means that hitting into the offer with a one lot will
not cost you much money if you are wrong on the trade.
So the idea here is to make a new high in the 5yr note while holding a long position in the bond. If it
works, and the new print in the 5yrs helps push the 10s and 30s higher, its highly unlikely that it will
be for more than a few ticks in each. That being the case, have your offers in each market a just few
ticks away ready for an exit.
There was a 305 lot on offer in the 10s and just over 700 in the 3s. Heading into the data, these
numbers were not moving. This suggests that order will be there regardless of the RBA decision on
rates.
Whats the setup? The overall opinion on what the RBA was about to announce was split 50:50. They
were either going to cut or leave rates unchanged. That meant, the market was about to move in
one direction or the other. The chances of the market holding flat were one in a million.
With a quick trigger finger, hitting into those offers if the RBA announced a cut would be the trade to
make.
As it turned out the RBA left rates steady and there was an immediate gap lower. There was the
potential to get short, but not immediately. If there were resting orders on the bid side, there would
have been a good opportunity to hit market as quickly as possible.
These trades do not present themselves on every data release, but they come up often enough.
E. Data Pullbacks
When trading a reaction to data, quite often a market such as the Aussie 10yr bonds will give you
more than one chance to get a trade on.
Following on with the RBA announcement as discussed above, the decision not to cut rates triggered
a sell-off in the Aussie bonds. What was interesting was the move in the 10yr bond.
After the initial reaction, which happened too fast to click into, the bonds pulled back a touch, giving
an opportunity to get short before the next move lower (circled).
At the time, how do we know it will move lower again? Well we dont. The first point to make
however, this is a falling knife market. We know not to try to catch the falling knife. That is, we
dont fade the move that is the immediate reaction to data. For the first minute or so, it should be a
short position or nothing.
As the market paused and traded up a few ticks, the thing to ask is whether this is the end of the
move or part of a continuation. The answer lies in looking to other markets for a little perspective. In
this instance, the Aussie 3yrs were down 7-8 points on the day when the Aussie bonds were all up a
tick or two.
There is no way the market would not continue into negative territory when a) we have just had
bearish news and b) its 3yr counterpart is down 7-8 ticks. You could also add that the market was
still a few ticks away from the nearest technical support level if you look at that sort of thing.
That little pullback was a perfect set up and a great opportunity to get short and ride it for a few
more ticks.
These types of pullbacks happen often enough to take advantage of and at the very least if you are
wrong, waiting for the pull back to enter the market still gives you a pretty low risk trade compared
with hitting market in the direction of momentum.
F. Other setups
All of these set ups simply describe how these markets behave. If you think about it, that is all a
setup is an understanding of how a market behaves so much as to find repeatable patterns.
Exactly how a setup unfolds is always changing. One day, a market may be following the Tnote
exactly, the next it might be doing the opposite. Sometimes there are identifiable reasons for this
and other times there aren't.
Reading the market is not about applying a bunch of rules that some Guy came up with. Its about
spending enough time in front of the screen so you can understand how a market is behaving and
spot the opportunity.
More information
Book: Trading STIR Futures by Stephen Aikin
http://www.amazon.com/gp/product/1897597819/ref=as_li_ss_tl?ie=UTF8&tag=mrrnk20&linkCode=as2&camp=1789&creative=390957&creativeASIN=1897597819
CME Treasury Futures General Info:
http://www.cmegroup.com/trading/interest-rates/yield-center.html
CME Treasury Futures Duration and DV01 Tool:
http://www.cmegroup.com/trading/interest-rates/duration.html
Measuring the price sensitivity of U.S. Treasury Futures doco:
http://www.cmegroup.com/trading/interest-rates/files/Empirical_Duration.pdf
Calculating the Dollar Value of a Basis Point doco:
http://www.cmegroup.com/trading/interest-rates/calculating-the-dollar-value-of-a-basis-point.html
Contact details
Guy Bower
guy.bower@propex.net.au
www.propex.net.au
Disclaimer
The information in this document and related documents and communication is intended for inhouse educational purposes only and does not constitute advice. Redistribution of the material
without prior permission is prohibited.