|
PureBytes Links
Trading Reference Links
|
Folks:
I had meant to post this this weekend, but the weekend was over before I knew
it. Anyway, maybe it's in time to spark some thoughts in someone...even if you
don't use the ideas to trade for the moment, you can always watch the markets
and look for spread trades.
I think when most traders think of spread trading, they think of different
things depending on their trading background. I started as a currency trader, so
originally, when someone on the floor told me they were 'spreading it off,' it
meant they were long or short against the DM, say, and rather then close the
position, they decided to make a trade in the opposite in the swiss usually;
sometimes they would spread it off against a month further out in the DM, but
that was rare back then [early 1980's].
As I learned more about the markets, I learned that the interest rate
differentials between two countries helped drive the two currencies in opposite
directions; in the cash currency markets, we called that trading crosses,
although it was still spreading on the IMM.
A little later on, I began to trade currencies that were very prone to
devaluations. Now, the trick to making money when a currency devalues is not
what most traders think: Most traders think that if they are short a currency
that devalues, they get the big prize. The fallacy of this notion actually comes
from the experiences on the IMM, where a trader's position is already funded to
a date well into the future. But in the cash markets, almost all the volume
that's traded is valued for spot [one, two or three business days from today,
depending on the country]. And so countries that were 'forced' to devalue found
a tool to pay back speculators that were short their currency--If you are short
the currency for value spot, you have to borrow overnight money--and so the
countries one by one learned that they could literally drive out speculators by
drying up the overnight 'call' money. It wasn't unusual for overnight call money
to go from an annualized rate of 10 percent to something approaching hundreds of
percents for a few days, which quickly cost a speculator that didn't have his
position funded outright to a future date before the devaluation.
And to really take advantage of these trading opportunities, I had to learn to
trade what we called 'forwards,' and these are arrangements to buy a currency
for value spot and then sell it back at a future date at a price that is figured
by the interest rate differential between the two currencies and the number of
business days. And of course, if you had funding prior to a devaluation AND you
were short the currency, you got all the marbles. In fact, there are many
devaluations where if you had good timing [or insight or inside information] and
borrowed extra funding, you could make much more than you could make on the
devaluation than you would have being short the currency. And with less risk
[the one risk would be if you didn't unload the extra overnight funding before
the demand dried up, your profit would also dry up].
Later, I learned that the same interest rate plays could be viewed inside a
country, meaning that if I felt there was going to be pressure on the currency
to fall, there would be a demand for overnight funding in that currency, because
speculators would be needing funding. And it wasn't too many steps from that to
learn about the interest rate tools that can be used for trading when you feel a
rate change is about to happen in a country, whether it's because there is about
to be an official rate change or because speculators were going to force the
rates to change.
Speculators force rates to change? Yes, you read that right. Look at the Fed
here in the US. I guess some people are holding their breath about the next Fed
meeting, but in reality, the markets, the speculators, have already spoken on
the issue of lowering rates. We have been having a RE-valuation here in the
sense that capital has been pouring into the US bond markets and overnight
deposit markets. Sometimes the the officials of a country change the rates, and
sometimes, the markets change them for the officials.
Now could we profit on these changes if we see more of them? Sure--there's the
obvious plays of being long eurodollars, or long bonds or long t-bill futures.
You might even decide you have an opinion about what the currency markets will
do if the Fed changes rates. But did you think of spreads? They may not be as
risky, and in a long trending interest rate environment, they might be a better
play. Or another play. For example, how about one of Neal's favorites, the NOB
spread? If you think the Fed is going to lower rates, rather than just being
long bonds, you might instead choose to buy ten year note futures on the CBOT
and sell bond futures. The theory is again that if the Fed lowers rates, the
shorter the duration your exposure, the more it will benefit from this type of
change. The lingo here is that you would be putting on a spread to take
advantage of a yield curve change, in this case the yield curve would be
steepening [we are at a really flat yield curve right now...in fact, in the past
month, the ten years in relation to the bonds has been at an all-time high].
Another play would be to buy two year notes on the CBOT and sell five year notes
on the CBOT. Again, less risky than an outright trade, and depending on how it
reacts, it might move more than being just outright long a risk adjusted amount
of five year notes. Or how about long the two year notes and short the ten year
notes? It's more risky, but if you get the 'inflection' of the yield curve right
[the place where it's slope changes the most after a rate change], you would
gain the most. Or for those risky spreaders, there's the 2 year notes against
the bond future. And to really throw out possibilities, some people do this one
in ratios of the number of two years to the number of bonds...
And last but not least, the lowly eurodollar future. When you stand near the
eurodollar pit on the Merc, the number of thousand lot trades that are traded as
you watch is mind numbing. Banks around the world buy and sell them by the
thousands all day long. It's the one pit where even if you have a large amount
of capital in your trading account, when you call the pit directly, you don't
ask for a live quote because you're worried about the skid: The bid and offer
have little spread and they can do your amount ...period, so it's polite to tell
them what you want to do, and then ask them to give them your fill [and it
matches your screen]. So euros...they are tied to overnight rates, and then the
delivery dates give you exposure to 'term' interest rates. So if you are trading
the Dec 1998 eurodollar futures, you are basically trading overnight call money
in the US [very close to T-Bill rates]. As you move out to six month eurodollar
futures, which might be March 1999, you are now out a tiny bit on the yield
curve. This means they are trading something like 90 percent like overnight
T-bills and 10 percent like two year notes. And by the way, they make eurodollar
markets out many years [to at least 2007 right now...probably further]. So
another spread that you might consider would be to buy the nearby eurodollar
[Dec 1998] and sell a eurodollar future further out [say the Dec 1999]. Or you
can make the far eurodollar future further out...the further out, the more risk
in the spread, but compared to two year notes spread against 30 year bonds, the
risk is much less. But there is still a great deal of money to be made trading
even these near-by spreads.
That's my thougthts on the possible trading you might want to think about when
you get an itch that rates might change in a country, either here or elsewhere.
You can take a position in a currency, or a bond, or a swap or make it a spread.
There's always a way to express your trading idea.
I hope this is helpful information to some of you. I'm sure a few people will
correct the errors or point out better ways to explain the risk involved, or
even share some better trading ideas, either in spreads or in interest rates.
Best,
Tim Morge
|