Execution that hurts

Yesterday, on the 1.25 point sell off in the US {30 year} we decided to play the 'mean reversion' game and take a shot at getting long some upside calls.

We purchased the December {Z} 137 calls for 20 ticks. Our motiviation was as follows:

1. We are currently at the 60 day support level in the USZ {roughly 130}

2. We are anticipating a stock sell-off as well as the corresponding bond rally following next week's supposed QE2 announcement.

3. A trusted adviser taught me that when all else fails and you have no idea what to do, buy gamma.

{they're currently priced at 11-12}

Other things we've done or rolled out of.

1. We have taken 75% of our E0X 91-93 put spread off. We purchased it for 3.5 and have sold it for an average price of just under 5 ticks.

2. EDU v FFU, we purchased 28.5s in the spread and sold 31.5 and 32s {completely exiting the trade}

Finally, my Philosophical rail Defender alerted me to the following theory about the Nov 3rd announcement. Fascinating opinion. {this text comes directly from an IM conversation}

So here is my 10 delta prediction, {we'll get} no explicit announcement of QE, stocks tank, PIMPCO takes it on the chin and puts back {their long book of} MBS to Bank of America. The Govt does a Citi/GM style bailout with BAC. {As a result} Geithner gets ousted {and either} El Erian or Gross will move into the drivers seat at Treasury. They will then propose a bailout of state pensions via the Treasury issuing 100 year bonds at 6 pct in a swap for all pension assets. Then the Fed continues to stealthily purchase everything not nailed down.

~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

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

Possible Plays and an Update

What's worth doing right now?

We've sat around for a couple of days scratching our heads over what should be done in order to best capitalize on our current environment. If you'll recall, the last posting on what we're trading {here}we talked about a long July put spread in the bonds and a long call 1x2 in the September EuroDollar Futures.

To be brutally honest, we've taken some heat on both. 

Bonds:

As we traded higher following the rapid decrease in the S&P the bond option volatility became jacked! Though it wasn't enough to offset the 3 point rally we suffered with a short 5 delta, it did lessen the blow and provide us an opportunity to roll it around. In order to capitalize on the sudden rise in volatility we executed the July 114 - 115 put spread 1x2. By buying one July 115 put and selling 2 July 114 puts we effectively traded into the July 114 -117 put spread 1x2. This offers us the chance to make a profit anywhere between 117 and 111 in the September bond future. It also creates a short vega position meaning that as the market calms down and volatility decreases, this position will gain in value. Our average cost for the trade is now 9 total ticks.

Euro Dollars:

Our 95-96 call 1x2 is a bit underwater. We initially paid 3 ticks on that trade and as of the close today it was quoted 1.5-2. I firmly believe that this is the correct play and would advocate adding to any longs you've accumulated. This European drama will end and you have plenty of time to have the Libor stay put or slightly retrace.

The Future:

The skew {combo/risk reversal} in the bonds right now is very well bid to the calls. {The combo is usually constructed by equal-distant calls and puts. Price is derived by subtracting the less expensive from the more expensive. 9.5 out of 10 times the PUT is more expensive than the CALL} In the September options {expiration 8.27.10}the premium is +8 ticks to the call. This is the fear trade. Right now, locals {and paper}are scared that the bonds will make a dramatic run-up just as they did back in November of 2008. To capitalize on this, you should look at the September 104 - 108 put spread 1x2. Currently it is priced around 2 ticks with the premium going to the 108 line. This means that you can sell it for 2 ticks and be long 1 extra downside put. Here is my thinking. 

*If the market continues on it merry way and continues it assault on sub 4% long term rates, this trade will expire worthless and you'll keep your 2 ticks of profit.

*If the market makes a powerful correction in the next 95 trading days there will be a change in the combo. Locals and paper will realize that the puts are undervalued and that skew could flip as much as 12-16 ticks. When that happens, this trade will profit handsomely as you're actually long an extra put for just such an occasion.

*If the market screams lower, you do have exposure between a futures price of 108 and 100 in the September future. Just for reference, those prices represent a 30 year bond yielding more than 7 %.

~LH

Mixing ED with US

Here's a couple of plays we have on going into Friday's unemployment number. For the record, I fully anticipate a blowout number. Something in the neighborhood of +275K with bottom-line rate unchanged at 9.7.

I say this for two reasons. We need good news for the equities. Other than traders, I don't think anyone likes fear. The VIX is high and the risk aversion is creeping back into the marketplace. If there was a month to finally release all the census workers' hiring data, this is it. April was free of strange weather events and random holidays that would have slowed the hiring process. We should see the full effects from the the 1 million jobs the census created {though we'll pay for them later} and it will make the Mom and Pop investor feel more confident after the likes of the Goldman Sachs scandal. Secondly, I'm not sure that the market will care what the number is, and are looking for any excuse to rally equities and sell treasuries. The panic flight to quality this morning was overdone IMO and regardless of what the US Government releases in terms of data, equities go higher yields do too. So, in a round-about way, I think we get there with a banging number or not.

Since we were so convinced that the Ten Year is going to reject the 3.50% yield line, we decided that we would execute a put spread in the bonds. We selected the July 115 - 117 put spread for 25 ticks. It has a 12 delta. We don't actually expect to keep this trade until expiration, rather as we grind lower, we hope to profit from its appreciation and sell it out. Below is the chart:

During a conversation with a large ED options trader, he noted a couple of plays that he thought would be decent risk/reward trades. However, his most salient trade thought was that he foresees the 99.625 line as a 'pin risk strike'. By that he simply means that we may trade up through it slightly but when it comes to settlement, LIBOR will settle as close to .375%  as possible and the options written to that line will become worthless {both the calls and puts would expire at zero} We really enjoyed this logic and decided to put some skin in the game and test it out.

We purchased the EDU 99.50 - 99.625 call spread 1x2 for 3 ticks. If our ED trader hypothesis is correct, our call 1x2 will settle at 12.5 ticks netting us 9.5 ticks {Sept ED settling at 99.625}. If LIBOR explodes and starts printing in the .75% to 1.25% range we simply lose our premium paid (in this case, 3 ticks). If the world settles down and risk becomes a moot point again, our breakeven to the upside is 99.72 in the September ED. That seems like an unlikely{though entirely possible} level, but one that we're still willing to take a risk on.

~LH

Confucius say ...

"He who pick bottom, get stinky finger" (perhaps my favorite 'market timing' quote--obviously not Confucius)

Friday was a very abbreviated session that gave the credit markets a quick and solid beat down. Not only did every interest rate product move lower, but the spreads started moving as well (as opposed to the unilateral moves we've had recently)

To us, this signals a good sign. The marketplace is finally starting to price in a recovering US economy and all of the impending policy maneuvers that will accompany this revival.

Here's a few points of interest:

• As of the close yesterday, the Fed Fund Futures were pricing in a 43% chance of a 50 bps rate move at the January 2011 meeting. (Also known as an 86% chance of a 25 bps hike)
• Our closely watched NOB (Notes over Bonds) yield spread touched 86 bps on Friday. In the full session yesterday (Monday 4.05.10), it did NOT react as we had expected. Recently, when the short end (ED and 2 Yr Notes) sell off, the NOB goes negative (in relative terms, the 10's are underperforming in relationship to the 30's and the spread between their yields is increasing) Yesterday, even with a aggressive sell in the futures market, the NOB stayed constant at 88-89 bps. This signaled to us that the market wasn't fully convinced that yields were headed higher. Early price action today, confirms that assumption as they are drifting higher in early trade.
• General market consensus is that this week's auctions (all 8 of them ranging from 4 weeks to 30 years) will be met with mixed demand. Most talking heads have been harping on higher interest rates due to investors REQUIRING more bang for their buck. We disagree. Foreign investors were quiet at the last few rounds of auctions as they sifted out the mixture of data coming from the US. We anticipate very robust auctions and a drop in current yields (especially in the TY and US contracts).

We got long the following:

1. In the Ten Year (TY) we bought the 116.5 - 117.5 call spread for 8 ticks. Risk is 8 ticks, potential profit is 56 ticks (64-8). We're looking for a good TY auction on Wednesday and will probably be out around 14-16. {SOLD OUT AT 15 vs. 115.30 TYM10 Netting 87.5% profit}
2. In the 30 Yr Bond (US) we're long the 116-117 call spread for 13. Same parameters, just looking for a pop.{SOLD OUT AT 22 vs. 115.21 in USM10 Netting 69% profit}
3. We're still hedged up for a move to the downside in the Euro Dollar (ED). We still have the E0K 9837.5 - 9812.5 put spread 1x2 on for a half a tick. We're long the 9837.5s to be short 2X the 9812.5s. This trade pays off if the June 2011 ED settles below 9837.5 on May14th.
4. We took off the E0J put spread 1x2 for a 75% profit.

Closing thought:

• A large hedge fund in Greenwich CT. initiated a US 117 - 119 call spread 1x2 this morning. They bought the 117 calls and sold 2X 119 calls. They did 15K (15,000 x 30,000)! In my opinion, they have the same thoughts as us. The only difference is the timing (We put all of ours on yesterday) and size (We didn't do 15K)

This is the week of supply.

~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

Updating the MGC (Monday Great Calls)

Here's the update going into the PPI data tomorrow and Friday's CPI.

1. Closed out the UL vs TY spread at 120.21 and 117.205. This trade netted 1007 ticks ($31.468.75). In its place we've intiated a very basic NOB. Re-initiating, with the US 63 @ 116.27 and sold the TY -100 @ 117.205
2. Buy premium, the VIX is too low. (See SPU section #6)
3. Hold on Euro FX positions
4. Look to sell the AUD over .9050
5. Currently Long this U vs U spread and looking to sell 31s
6. Purchase the 1095 SPX straddle for 12.40. Look to hedge below 1085 and above 1115
7. Neutral. Flat CL after getting to the expected target.

 My gut says that the PPI & CPI data (Bloomberg Calendar) will be a complete duds and the overall market will slowly drift towards unchanged for the week.

LH

Monday Mornings are for Great Calls

Here's my play book for the week ahead. We're actually closed Monday so it will give you a bit of extra time to digest what you'd do with these.

Plays for the week:

1. Using the new Ultra Long Bond (UB), I would like to put on a BOB (UB vs US) vs a NOB (US vs TY). Broken down, the US portion actually cancles itself out and what you're left with is a Long UB position vs. a Short TY position. Here's the ratio used: +28 @ 121.25 UL and -130 @ 118.04 TY
2. The VIX is simply too high (currently 24.05). Expect the VIX to settle around 22.5 on 2/19/10
3. Euro Currency. The previous week has been a roller coaster and there is little doubt this will continue. It should stay between 1.3350 and 1.3850 as long as the Greeks keep up their end of the bargain (currently 1.3590).
4. The AUD is the personal favorite risk currency of my associate Practical Thinker (Mr. PT for short) and his call for this week is to remain between .8750 to .9050 (currently about .8840)
5. Expect the Eurodollar vs Fed Fund Sept 2010 ratio to remain in a very tight range of 31 to 32, buying dips and selling spikes (currently 31)
6. Expect the SPU to hang tight inbetween 1050 and 1090. However, a violation of the 1095 line will mean higher highs (currently 1073)
7. Finally, the Old Baron in our office has proclaimed that oil (CLH10) is a screaming buy and will settle on 2/19 right around 77.50. (it is ~$74)

This is the playbook. If this week somehow produces a market moving catalyst the play will be cover or take profits sooner than Friday. I don't anticipate any of these positions lasting for more than a week. My gut says the world is just a touch to dynamic.