Jun 25 2009
If the US is Japan, Buy Long Bonds
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.
Here are some other posts which might interest you:
- A Eurodollar Convergence Trade
- Update on Eurodollar Trade Idea
- Updates On Recent Eurodollar and Bond Trade Ideas
- Lots Happening for Bonds This Week
- Playing for a rise in interest rates
Hello, interesting post. Can you explain the risk/reward further please? I only have a basic understanding of options, and would seem to me you’re suggesting buying an OTM call (so giving you the right but not obligation to buy) at 127 when we are trading way below that currently. I don’t understand why you would pay the premium to go long at 127, why not just go long a future or ETF now at current prices? If it’s going as high as your friend states, then by the time it gets to 127 you’ll already be well up.
I think I’ve missed something but I don’t know what it is.
Bob – The idea of the option trade is that you commit less capital to the position and that you have a lower and pre-defined risk. Going long the futures or the ETF does not offer that same ability. Of course there is the trade off of needing the market to move a lot by the time the option expires. The very positive risk/reward aspect of the out-of-the-money call comes from the fact that for a small risk (1 pt for the 127’s, for example) you have an extremely large upside potential. If the bond were to trade to 155 as might be the case if yields fell into the 1%s the 127 call option would be worth at least 28 pts. Whether that’s a good trade for you depends on what you think the chances are of bonds making that kind of move by the time the option expires.
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