Rhody Trader

A colleague of mine pointed out what he considers just about a no-brainer trade that can be made in the Eurodollar market (please note, I’m talking 3mo Eurodollar futures which trade on the CME, not EUR/USD). It starts off with the following question:

Do you believe the Fed is going to raise rates this year?

If the answer is no, which I’m guessing most people believe at this point, then there’s a convergence trade which can be made in Eurodollars. By that I mean we can put on a position now that is a play on further out contracts converging over time toward about the current LIBOR rate (upon which the Eurodollars contract is priced).

As you can see from the snapshot of recent prices for the strip out to December, the front June contract is currently pricing in a LIBOR of 0.645% (100 – 99.355), which is basically where LIBOR is currently quoted in the market. The December contract, though, is pricing in LIBOR of 1.265%, nearly twice as much. The convergence trade idea is that if the Fed does not hike rates between now and year-end, the December Eurodollars will move toward a price more or less in line with what we’re currently seeing in the June contract.

There are a couple of ways to play this.

1) Buy December Eurodollars: If the Dec contract does reach something close to where the June is currently trading it would be a gain of about 60 bps, or $1500 ($25 x 60). That’s a fantastic return given the relatively low margins for Eurodollar futures.

2) Buy a call option on the December Eurodollar futures: The at-the-money 98.75 calls were recently trading at about 32bps for a cost of $800.  That would mean a return of just under100% if the futures go off at 99.35.

3) Do a call spread on the December Eurodollar futures: This would involve something like buying the 98.75 calls and selling the 99.00s. The benefit here is that the spread is cheaper than doing a straight long call trade as the net cost would be only about $375 ( 32 – 17 = 15 x $25). Of course the upside is capped at only 25bps (the difference between the option strike prices), so the maximum profit would be $250, so the % return is a bit lower.

Of course this isn’t a totally risk-free trade. The Fed could raise rates. Also, the spread between LIBOR and Fed Funds could widen, meaning that even if the Fed held rates steady, LIBOR could still rise, eating into the upside convergence in the December Eurodollars (of course the spread could also narrow).

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