Rhody Trader

Just a quick update on the Eurodollar Convergence Trade. 

The current 3mo LIBOR rate is now about 0.44%. If that were to hold the December Eurodollars would settle with a value of 99.56. Recall that they were trading at about 98.735 when I wrote up the trade idea, so that would be a gain  of over $2000. The EDZ9 is currently at 99.405, so there is a little bit of room yet for convergence.

The Dec 98.75 call was the at-the-money option at the time of the intial post. It had a price then of 32.0. According to the CME web site the latest price was 69, meaning the options are up  about 115%.

And of course the 98.75/99.00 call spread is at maximum profit right now.

The If the US is Japan, Buy Long Bonds hasn’t really done anything much so far. Bond prices are about level with where they were when that was written up, having given back some earlier gains.

Just wanted to follow up on A Eurodollar Convergence Trade.

There’s been a lot of movement in both LIBOR and the December Eurodollar futures. A quick check shows 3mo LIBOR at 0.51%, which means the break-even value for Eurodollar futures is at 99.49. The Dec contract was recently trading at 99.23, so if LIBOR holds at current levels there’s still about 26bps worth of convergence left to be had in the next 5 months. This is on top of the 50bps the futures are already up since that original post.

As for the options, here’s a snapshot view of the current action. Unfortunately, the 98.75s which were the at-the-money calls when I first wrote-up the trade idea are no longer in the frame of the more actively traded ones. Even still, we could come up with a rough idea where they are currently trading. The 99.125s are trading about 15bps above intrinsic value (25bps less 99.23-99.125). Applying that spread to the 98.75s and we get a price of something like 63bps. That’s nearly a 100% gain on the 32bps which would have been the original cost, with the potential for more.

As for the call spread I outlined, buying the 98.75s and selling the 99s, that”s basically already locked in at or very close to maximum profit since the market is well through the 99 level.

On the If the US is Japan, Buy Long Bonds trade idea, December T-Bond futures were up through 120 yesterday for a little while. That was a 4 point or so gain from when I wrote up the idea. Of course this is only chump change compared to the idea of how far the market could go if the underlying idea is right, but it’s a good start.

First, let me provide and update on the Eurodollar Convergence Trade, which a colleague of mind suggested.

As of this writing the December Eurodollar contract is trading at about 99.11. That’s a gain of about 35bps. I can’t see a current quote on the 98.75 Dec calls, but the 98.875s are quoted at 37.5. That option is 23 bps in the money, meaning 14.5 bps of premium. If we use that as a rough guide then the 98.75s are probably in the 49.5 area, a gain of 17.5 bps from when I wrote up the idea. The 98.75-99.00 call spread is probably at about 22 bps now (99s quoted at 27.5 right now).

In other words, one could close the trade out now with a pretty nice two week gain.

Now, that same colleague has a new trade idea. I’m not sure I necessarily agree with him on the premise, though. Basically, he thinks our interest rate profile is destined to look that that of Japan. That means our long rates are due to slide way down, potentially into the 1% range. That’s obviously a big rate drop from hear, meaning bond prices would shoot higher. The plan, therefor, is to buy long-dated well out-of-the-money call options.

Here’s a look at the front month T-Bond futures chart.

The peak was near 140 back at the end of 2008. That was when yields were down around 2.5%. If my colleague is right then the futures are headed for an even higher peak, potentially something in the 155 area. If so then massive gains are certainly possible.

Taking a look at the recent December 2009 options quotes (the only ones I have immediate easy access to at this moment, I see that you need to get out to the 127 strike before there are prices below 1 pt ($1000). Ideally, you’d probably want to go out further than that in terms of time, though, so the cost will be higher. Still, the risk/reward ratio would be fantastic.

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).