Silence wasn't golden

In some respects, I find it very difficult to write after getting pounded. At other times, it's actually a stress-relieving endorphin that allows me to refocus my thinking.

To be blunt, some of our assumptions of the QE2 announcement and the subsequent market follow-through were just wrong.

I do want to update some of our larger trades now that we've had a rally, a pull-back, and rolled plenty of our inventory.

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In the 30 yr bonds:

We sold out of our longs in the 137 calls prior to the QE announcement.

In the March Euro Dollar:

We rolled our March 9925-9950 put spread out to the June 9925-9950 put spread. We executed near the highs of the move for a cost of 1 tick. This will provide us with 3 more months to catch the credit event we still believe is looming.

In the March and May trees:

We have covered the March and we're in the process of covering the May. We originally put the on for a credit to the 1 leg and we're now selling them for even money. This helped us finance our ED put spreads and we are actively looking for ways to get some more premium shipped in, ideally in the FFs.

The NOB is still at 25 year highs. The range on Wednesday was almost 2 points. {that's 64 ticks at a price of $156 per one lot} Though it settled off the highs, it was up over a point. At this point, we have no position on as we attempt to reload and find a position that will allow us the capture what we think is the impending flattening.

~LH

Get Long {might be wrong}

Our markets are slow and getting increasingly cheap. A few thousand contracts here and a few hundred over there is about all we're seeing these days. ED volume has fallen to new lows in total contracts traded. It's as if the world is in a post Thanksgiving induced coma. It has been fed cheap money in infinite amounts. Now as it lays and tries to digest everything, its being lulled to sleep in an environment of sinking volatility.

I'm seen this movie before, somehow it always ends in tragedy. {However, it is only painful if you are caught holding the potato when the music stops.}

Few of the things we would like to do.

1. ZH diagonals in the TY and US. I would like to grab some cheaper gamma and finance it by selling wings. Ideally, we would like to do this with puts. Our medium term outlook {3-6 months} is that we'll stay range bound in the yield curve with moderate moves within the range that will help you to finance your decay. {Z28p v H21p gives you positive 6.5 gamma for 2.75 ticks of decay a day}In the event of a credit meltdown, we suspect the bonds will go higher, making a short longer dated call a risk to your overall position.

2. In order to capture the 'cheapness' of implied risk, we think that you're best served putting on steepeners across products in FF v ED {sell the ED and buy the FF}. Of particular interest to us is the EDU v FFU. The spread between the two of them has recent traded at its low {28} and it provides a couple of plays as we go forward. a) if the world ever gets frightened by credit risk, European or American GDP, or some other nascent economics flag you'll most likely see the EDU react in a much more violent way then the FFU. b) under current decay models, the EDZ v FFZ is at 17 with a QE2 bump priced in. This means you have a pretty solid floor at -9, though we are looking at a stop around the 24 range and an anticipated exit at 40.

3. We still like being short the NOB. If you can stomach the stress, it has a long way to fall back towards reality.

~LH

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

NOB and CTD

This is our custom made graph showing the current Cheapest to Deliever (CTD) 30 year yield vs 10 year yield as it relates to the cash markets.

Though our CTD chart shows the NOB at 144, the spot future NOB (CME traded) is only at 134, this tracks the two spreads relationship to one another.

A weekly chart of the generic front NOB contracts dating back to September of 1992 along with the 50, 100 and 250 simple moving averages

The NOB continues to make multi-month year highs as the shorter end of curve sprints towards zero. I pulled up the generic front future NOB and asked my Bloomberg for the high, the low and the mean for the time frame 9/92 through today {10/8/10}. We're at the high, as in right now it is creating a new high water mark for the 18 year period. Historically speaking, we're 100 basis points over 'average'. I understand that we're in a new and "exciting" time but I have to think that some type of retacement is necessary. At a minimum, how can we structure a trade that allows us to risk limited premium and yet capture unlimited returns as we crash back towards normalcy?

~LH

Sizing up my opponent

Mid-September and I have plenty of irons in the fire. Yet the daily grind in the Fed Funds is slow and sometimes arduous.  The idea of growing our single accounts into a larger, more macro-focused trading vehicle has begun to effect my thoughts and the process by which I believe trade creation occurs. The Greek philosopher Heraclitus wrote, "Nothing endures but change." {We often hear it translated just a bit differently as, "Change is the only constant."} My newer approach is to pull back from the one tree from which I'm picking apples and take a look around me to see if there is any low-hanging fruit on another trees nearby. Why strain for the next marginal piece of fruit in my tree when there is a perfectly good piece of easy fruit on the tree right next to you? All that to say, I want to expand the book and create a greater exposure and presence markets that relate to the FF.

I've been at this long enough to know that most of my trades don't just appear out of nothing. A majority are created out of a calculated premise, a lengthy discussion and the intangible of experience. However, if we are to aim towards a more macro goal, I think the process can shift to a round table conversation where we answer the following questions:

1. Where do I think we're going tomorrow in the products that we trade?
2. What is the best trade for tomorrow?
3. What is the best trade for the next few weeks {3-6}?
4. What is the best trade for the quarter?

 I don't necessarily have the answers to any {all} of those questions at any given point, but collectively the answers will emerge. What I've described is the goal. How we actually go about getting to that point; well that's the adventure.

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I want to shift gears a bit and just briefly lay out some of the trades we've been working on over the last few weeks and months.

• In the FF we've been selling the 87/93 call spreads in December and February. We've been able to collect between .75 and 1 tick {1 tick = $41.67} and though they aren't "make your month" trades, they do help us finance our other positions.
• We've sold the March 68/75/81 put tree {-1, -1, +1} and collected an average of 1 tick. This trade leaves us short two downside puts and long one put that is currently ATM. If nothing happens in the Fed's policies or rates for the next few months OR we move higher in price {lower yields} we will simply collect our tick and be done with it. If however, we start to move lower, we're long a put spread with 1 naked short put below. The break even for this trade is roughly 9961.
• We've also done the May 68/75/81 put tree as describe above. However, we were able to collect an average of 2.75 ticks to sell the two legs and buy the one. The thought process and the theoretical payout is very similar.
• We have purchased the EDH {March 11} 92/95 {9925/9950} put spread in the Euro Dollars. Partially as a hedge against our FF put trees and partly to allow some credit risk exposure. Our thinking was if another European nation even hints at some type of sovereign wealth issue, the ED will react much more violently than the FF. We paid an average of 4.5 ticks {1 tick = $25}. The maximum this trade is worth is 25 ticks {less entry costs} giving us a very nice 5x1 on our money if it hits.

As far as what is out there but not quite ripe enough to pick? I think that the NOB is getting very attractive as a short position. The yield curve has been pricing in some type of QE2 coming out of tomorrow's FOMC meeting just as they did back in August. However, I find it difficult to believe that they will announce any type of easing coming out of an FOMC meeting. Perhaps they tweak the language, but nothing more. The chart below shows the generic NOB contract as generated by the CME. From its last top to the most recent bottom was nearly 80 ticks. At $156 per tick, that's a profit of ~$6,000 per one lot. I'm not sure how to best capture the pricing currently in the market. My gut says to get long USX {30 year Nov} put spreads and sell TYX put spreads for near zero cash outlay.

 ~LH

Quoting Pixar

Some weeks are harder than others. Last week was one of those weeks. Whether its the difficulties of a trending market or perhaps the pinch of repeatedly bad settlements it is with eager anticipation that I look forward to this new week. 

I desperately need to get Mr. Practical Thinker to write a piece or two on here. However, until he does, I will continue to poach his macro-mindedness and translate it into something we can all glean wisdom from. 

"You provide the food, I'll provide the perspective..."  (Anton Ego, Ratatoille)

This is not the first time I've stolen a line from Ratatoille (shameless plug: rent, borrow or buy this movie because its dialogue is supreme) and I hope broaden my "quotage" in the weeks to come but for now, you're stuck with the genius of Pixar. 

All this to say...the rumor-mongers and Mr. PT have done some adjusted my thinking by providing the perspective. If you've been following our execution you might have noticed that one trade we've gotten consistently right is our NOB (Notes Over Bonds) where we have sold the yield spread as it approached 100 basis points. On Friday, the spread between the two dipped to (and closed at) 89 bps and I desperately wanted to get long for the ride back up. 


The discussion was poignant and chalk full of salient information, but there were two quotes that I absolutely have to put on here. 

"I want to stay in a trade until it is blatantly obvious that I should have it on the other way"

 Two weeks ago, the NOB yield spread was trading 98bps and we sold it. If we (US) are really heading towards slightly higher short term rates and a better overall economic picture, one would expect a flattening yield curve. Why would we be in a hurry to tap out of at 90 or for that matter get long hoping to chop the last few basis points off of the giant's spear? Given where we believe the curve's rates are headed, we should have bet the farm at 98, looked to continue selling at 94, staying alert for any type of momentary blip while we continued to sell it until the 3 month low of 82 is taken out or we're so ultimately convinced that it is heading the other direction that we're forced to cover. Why would I give up on the right play? I think the answer lies within the Old Barron's wisdom of quote #2:

"It is so hard to stay long a winning trade, especially in this current trading climate."
That is so true. We're currently an office of grinders. We sit and grind through spread after spread, buying and selling both bids and offers while trying to not internalize to much of a position. Our ability to see the next tree and articulately describe it, inhibits our skill at seeing the actual forest. We are miss the global plays because we have our heads down and are furiously working at pounding out ticks. Though there is great wealth in "the grind," my guts says that the real money is in the being able to identify the trading climate you're headed towards and position yourself appropriately. Our tendency with winners is to close them out as soon as we've reached the maximum we were willing to lose. But trading isn't a bell-shaped curve. The best trades are great even if they retrace a bit and cause you to re-evaluate why you got into the position in the first place. Does the this particular trading strategy still hold water? If yes, you'll have to resist the temptation to close out and risk your chips a bit longer.


Needless to say, I didn't NOB it up. I'm actually flat. 


~LH

Play card: 03.09.10

What seems like a good play right now? Interestingly we've been a bit scattered on our picks, and though we've avoided a lot of trouble, it hasn't been easy.

If you'll recall:

• We were stopped out of our SPX play and covered all short deltas. We haven't bought any puts back in, but it is on the radar.
• We're long gold. Greed may have gotten the better of us as we got near the 1140 handle. In retrospect, it would have been prudent to place a stop around 1135. We didn't, and are still long. However, I've moved the stop up to 15 ticks 1110.{Stopped out 1110.50 on 03.10.10 we were off by 5 ticks!}
• Our U/U was brutally difficult to trade. After buying 24s and selling 27s a couple of time we were able to get the unit costs down to roughly 24.5 before getting flat at 28.
• The 'end-of-the-world' trade with FFJ vs EDH hasn't really paid off, though it is getting back to our levels and we would maintain a hold.

If you want to check on any of these click here.

Where does this quiet economic week send us? There are a few auctions in the yield curve however, the only piece of real data in my opinion is the retail sales number expected on Friday. Going forward, here where I'm focused.

• We're looking for a drift lower in the yield curve (though today's 3 year notes did fairly well at auction, drawing 1.437% with ~15% allotted at the high). If the long end (30 year) can below 115.28 we will be looking to sell 25 delta put spreads. Perhaps the 109-112 or the 110-113. 
• As the SPX continues to grind higher I can't help to get more and more bearish. However, after being stomped out of my last position I need to find a better way to express my opinions. Two plays come to mind: Short ratio called spreads and long cheap combos (risk reversals) 
• The J1175c-1200c call spread on a 2x3 ratio. You'll collect $7.35 (8.85 and 3.45 respectively) to sell the 1175 x2 and buy the 1200 x3. This provides you will a long premium play and a fat tail for protection.
• J1090p--J1190p is currently trading 3.60 to the put. That feels really cheap. I would look to be a buyer around $3.00
• The NOB spread is currently .98 bps. We sold the TY at 117.035 and bought the US at 116.17 on a 10:6.6 ratio {We reduced our exposure by 50% after netting 225 ticks, we plan on taking the balance off around 94 bps 3.10.10 UPDATED2: We traded completely out of this position buying 116.195 and selling 116.03}
• In the Eurodollar, I like being long high-octane put spreads. E0J 78-82 put 1x2 offers me that opportunity. It is priced off of the EDM11 (currently 9844.5). It costs 3.5 ticks and has about 6 weeks left. It break-even at 9821.5 and begins to lose money after 9784. This gives me 37.5 ticks to collect a profit.

 A few closing point lifted from my cohort in trading Mr. Practical Thinker:

1. Australian Unemployment is released tomorrow evening at 6:30 CST. This may finally be the catalyst that brings the AUD above .9225-.9250 and may provide an immediate term trade to get short looking for a retracement back to .8700

2. The chart here is of the SPX on a one week basis. Though it may be a bit difficult to read, it would appear to us that we have now ground through the free-fall area of October 2008. If we seriously get through 1148 which was the high set back in January, I would expect us to get up to 1175. From there, the next stop is near 1200-1225 (thus the 2x3). Failing to crack that 1148 level would potentially send us back down towards 1100 (thus the combos).

~LH