Conversation with a King

Remember when I introduced you to the 3 Kings? They were the three champions of the bond option pit whose trading savvy and skill produced millions of dollars in profits all while taking down paper from the masters of universe {read PIMCO & Goldman Sachs}. Most of these guys have moved on to 'greener pastures' and left the pit-life to the younger kids. But traders are creatures of habit and the longer you're in the game, the harder it is to turn off the constant internal dialog that was the key .

Knowing he couldn't turn off the dialog led me to ask about our current NOB dilemma. We've struggled for the past few days to construct a trade that limits our exposure while allowing us to capture what price action we anticipate in the coming weeks. Knowing that the kings had insight and perhaps the most valuable key: trading experience, I decided to seek out that wisdom.

Interestingly, it started with a question. He asked why we thought the NOB was going to make a retracement from its new 24 year high (149 bps)? I laid out our argument and theory.

• Paper is LONG the short end of the curve and getting longer. It has been the trade of least resistance and all pushed 2 year and 5 year yields to record lows. {Our office has discussed the real possibility of the 5 year yield going to 1% for the last 3 months...its almost there}
• There aren't necessarily 'sellers' in the long end {and ultra long} rather there is just a lack of buyers with respect to the huge amount of dollars being poured into the short end.
• We believe that a prevailing opinion is that: its better to be long these securities and in the worst case scenario they will to take delivery.
• The 5-7 year future {7-10 US Notes} hold the real possibly of recovery. 
• The biggest players have started to put on yield flatterns via the option complex.

He laid out his view of the playing field. Though similar, he saw the crux point from a different angle.

• The trade has been for paper {PIMCO} to hedge all of the mortgages they've bought over the last 2 years.
• Paper sees the government as the backstop of all these mortgages and {spoiler, this has a touch of conspiracy theory to it, PrD would be proud}since there was no way for the government to actually buy all the rotting paper out there they cut PIMCO in on a very sweet deal and virtually guaranteed their principle investment.
• Paper isn't viewing the 5-7 year trade. Rather they are staking out the QE2 announcement for the correction of the current trend.
• He suggested looking back 3-4 months and see what happened as the NOB self correct from 125 down to 110.
• He envisioned a 'non announcement' on November 2nd's Fed Meeting will result in a massive sell off in the 2-7 year notes.

The question we are forced to answer is: Are we on the mountain top getting ready to ski down the double black diamond or are we at the halfway point and preparing for the assault up 29,000 feet?

Realistically, are we traders that follow the trend or look for the mean reversion? I'd argue that we're the latter. Now to craft a play.

~LH

Guarding and Grinding

At times the environment is simply conducive to the aggressive, long style trading that I've grown accustomed to. Most of my grinding comes in the form of 'Micro Interest Rates' (usually Fed Funds and Euro Dollars) and a surprise move in the discount window Thursday created a porthole of opportunity to press the positions I felt as if I'd been milking for so long.

Hindsight trading is 20/20 and as usual, I wish I'd emptied my entire holster on Friday afternoon instead of holding back the last few rounds. In talking with some of the other traders around the desk, they too all expressed a feeling of lament for being reserved in their efforts. Yet, there's something to be said about that bit a reservation. It's that piece of me that has probably produced some of the longevity I've enjoyed through my trading career.

I discussed some of my early trading venues in an earlier post, but I didn't truly earn my trading stripes until I stepped into the Bond Options pit at the CBOT as an autonomous local. This pit, more than any other, taught me to press a winner but to never be without bullets.

It was the spring of 2005 and the volatility was getting cheap. Though none of us were clairvoyant, we could all feel a trend starting to develop. This trend would continue for almost 3 painful years and would encapsulate nearly 20% of the all-time low month/month volatility readings including a mind boggling 4.2 print in August of '06. {Historical Vols} But this is the place where I learned to watch the few titans amongst the our pit locals.

These "3 Kings", as I'll call them, were traders that would never sell premium on the first pop, rather they would sit back and watch what real paper was doing.  They all possessed that unique ablitiy to fearlessly buy it higher and sell it lower. As if they were all taught by the famed Jesse Livermore (Reminiscences of a Stock Operator), they never saw it as chance to empty their pockets when the first bid appeared. Rather, they were the ones buying it (usually through the pit brokers) from all of the smaller locals, myself included. Not that I wasn't happy to sell my book for a perceived profit, but it confused me as I watched the 3 Kings books swell under the immense weight of millions of dollars of gamma.

Then it happened. The real paper showed up. Not that small retail customers deck, no, these were the big houses that had to move a position. I suddenly learned an enriching lesson: real paper is 'price-insensitive.' They needed the options and they were willing to pay up in order to get them. Guess what, I was fresh out of bullets. I had let go of the options I had stomached as losers for the last 2 months, and for what? 4 extra ticks? It hardly seemed worth it. Yet there, across the pit in their own corner, the 3 Kings continued to bid premium in the face of paper. The unthinkable occurred next. It was like a game of chicken and PIMCO blinked. Their bid jumped 10 ticks and the 3 Kings unloaded the wagons. They dumped every bit of the longs they'd gobbled from the locals and in the process they even offered all the little guys around them a chance to get some real edge. They had created a marketplace and they had dictated what the price would be.

My first game-changing lesson was complete. I saw that if you sell on the first pop, you haven't guarded your longs and now you may miss the real trade. I would have plenty more opportunities in the next few months and years to practice this skill and ultimately refine it to the point I felt comfortable pressing it. The real mark of a learned skill is the ability to teach it to others...but that's another story.

One down. A multitude left. And as I finish this, I realize that my holster is re-loading quickly.

LH