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

Wyoming {Devil's Tower}

I got this picture from one of our brokers this morning. His comment is the caption. The crappy artwork is mine.

3 MONTH ?

~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

Executing for the Why

I am enjoying my front row seat the the show this morning.

In the blue trunks, standing slightly shorter now, is Interest Rate Volatility. In the red trunks, growing more powerful by the second, is the 4 ton gorilla named market angst. I've got to be honest, with all the movement recently {albeit in one direction}, the impending QE2 scenarios, Bernanke's 3 point attack as outlined at Jackson Hole, and the every pundit in the world calling for a Bond Bubble {and subsequently a massive sell-off}I thought that IRV would put up a little better fight.

NOPE!

The pummeling is merciless and I'm starting to get squeamish watching this. One of our market brokers said, "This is the lowest I've ever seen Mid-Curve EuroDollar straddles {vol} in all of my years down here." That must be bad.

Interestingly enough, we're long this rapidly rotting volatility. The other day we purchased E0X92 straddles vs 9929 for an average price of 16.5. Our current hedging has left us short deltas from an average of 9934.5 at roughly 60% hedge ratio. However, our next sale isn't until 9947 and at least prior to the NFP number, our first buy is around 9921. Good luck Mr. Gamma.

~LH

Booking Expectations

The addition of the newest office member has added an exponential increase in our trade idea generation. Though we have been substantially quiet in many of our markets, it hasn't been for lack of ideas, rather we're experiencing a total lack of conviction. As I type now we're in the midst of another spectacular bull session for the Euros. LIBOR has downticked to a paltry .28906%. In the last 15 trading days, the Green December ED {2012}has rally almost 40 ticks. The expectations of long term QE are all but assumed to be relevant from now through the 2012 calendar.

We're stuck with the questions of how profit in the zero interest rate vacuum. How do craft an option play that capitalizes on the market's perceived risks {that the market continues to drift toward zero? Over the past few days large ED customers have been buying thousands of EZ2 9925 calls at 1 {>30K}as well as the EZ2 9900-9925 call spreads at 4.5 and 5 {>40K}. Seriously!?! That's 40 ticks away and has 65 days til expiration. That's unbelievable. Though given the the last 15 days, it doesn't seem like much of a stretch huh?

Now we're drifting higher in price, lower in yield. The markets can't keep rocking higher, can they? What happens when QE2 gets released?

One of the more poignant arguments I've stumbled across lately is in a Bianco research piece. This piece focused on the amount of QE2 and hinges off of a Bill Dudley speech recently given to the Society of American Business Editors and Writers. Dudley stated that "$500 billion of purchases would provide about as much stimulus as a reduction ion the federal funds rate of between half a point and three quarters of a point." They then surmised that Dudley reached this conclusion by using the Taylor Rule to approximate a neutral funds rate.

"Using core PCE as a measure of inflation, the Taylor Rule places the neutral funds rate at -1.50%...With the fed funds rate essentially at 0%, the Federal Reserve has used asset purchases as a means to further decrease rates. These purchases have created almost $1 trillion in excess reserves as of 9/22. Taking Dudley's statement at face value, $1 trillion in excess reserves has already pushed the "implied funds rate" to somewhere between -1.00% and -1.50%. A further $500 billion in QE would push the rate to somewhere between -1.50% and -2.25%." {http://www.arborresearch.com/biancoresearch/}

Ouch, especially for our market. Maybe the large ED customers have read this idea too and are hedging best they can. Can you actually get negative interest rates?

~LH

Dialog of the Practical Thinker

A friend of ours recently sent me my first ever 6 page text message. In it, he was describing a conversation that he'd been wrestling with. Rather than summarize it, I think it would be best to put it up in it entirety so that the conversation can be correctly formed.

From the Philosophical Rail Defender (PrD):

I find myself asking the same question over and over. If globalization was the agreed upon mechanism to lead the undeveloped nations of the world forward and capital is finite, doesn't such forward progress require the developed nations of the world to give up a portion of their piece of the resource pie? 

More importantly, depending upon your answer, I'm also curious as to why the "richest", "most developed" nations are also those with the most debt (both public and private)? And, in the event of a large scale shift of resources between sovereigns, what would one expect to happen to the cash flow of said nations' debentures? 

I eagerly await your response. I suspect that the connotations our society has attached to "globalization" will present you with a unique challenge to weigh the working pieces of the process against the stratified public opinion of the subject. Will you be called a pragmatist or a protectionist, a capitalist or a fascist? I suppose it depends on how many people it reaches.

As these questions filtered in {through 6 text messages} I tried to identify the thrust of his real questions. I firmly believe that in order to formulate an answer, you need to know what is being asked. Though I have great respect the art of debate, I'll be the first to tell you that it isn't a defining factor in who I am. {The situation changes only slightly when I'm trying to convince you of a trade idea. However, I am surrounded by some individuals that have often put my intellectual prowess to shame. So in a brazen attempt to harness their collective genius, I asked my colleague, Mr. Practical Thinker, to expound on his views as the pertain to PrD's question(s). His response {as I would have predicted} is nothing short of exquisite.

From the pen of Mr. Practical Thinker:

Those are some serious questions to be sure. So much so, I've had to break them down to their elements in an attempt to answer. To begin, I'm not so sure there's a global consensus on how to move the undeveloped nations forward. I remember a fun factoid in the CFA curriculum (sorry no citation) about emerging markets and the global balance of GDP. We all know global GDP should grow significantly in the next 30-50 years but the tiny little secret no one wants to admit is the vast majority of that growth will be attributed to the strengthening currencies of those emerging markets. If you've grabbed a newspaper lately, you'll more than likely recognize that currency issues are grabbing the headlines almost everyday. Brazil's Finance Minister thinks we're at war over them! Japan, South Korea, Taiwan, Switzerland, the UK, the EU, and the US have all intervened in their currency markets explicitly or implicitly (QE is a stealth intervention in my book and buying member sovereigns isn't behavior for sainthood either). China's currency policy is fodder for the front page daily. Even if they are cheating (read: artificially weak yuan), they're sure as hell treating it like war.

Secondly, I'm not sure capital is finite. Even in the context of the Austrian gold standard, there's still a mechanism for capital formation through gold discovery. Fiat systems lack a considerable morality comparatively and capital is still up for a proper definition (tongue firmly in cheek).

So do we need to give up some of the resource pie? If the Chinese are going to play like that, we do. Global wage arbitrage has sure been a loser in developed countries and is getting difficult to swallow politically. Without aggregate demand reallocation in emerging markets, it will not get better any time soon.    

Why do developed nations have the most debt? I'm twisted between the chicken or the egg axiom and cultural progression on that one. What came first, big buildings or big loans? Probably the legal construct to secure property and intellectual rights and the sacrosanct structure of corporate limited liability. Once those are in place, a responsible banking culture should grow out of diligent risk management. Check India for horror stories on what happens if those events happen out of order. 

Lastly, how will a large scale shift of resources between sovereigns affect cash flows? Depends on the dynamics of the sovereign in question. If it was a developed economy, hopefully Say's Law would take care of them. If the country was mired in debt (the leftovers of credit, a once valuable resource laid waste) and couldn't pull the appropriate levers (read above) to squeak out alive, then just pay attention to Ireland as the ending to that tragedy is being written. 

Mr. Practical Thinker

Suffice to say, his deconstruction of the questions led to his ability to reconstruct an answer. Hopefully, that will satisfy PrD's questions. I'll close with this: Self awareness is paramount to crafting great decisions. In the same token I find it refreshing that Mr. PT has stayed out of the altruistic box while adding dialog to the attempted repair of global economic policy.

~LH

Perspectives on the Market?

Being friends with your broker can have a unique set of perks. Flying wingman to an economic round table turned out to be just that, a fantastic perk. I wound up in the audience for a Morgan Stanley Smith Barney market discussion moderated by Consuelo Mack that included the following:

*Jeff Applegate {CIO MSSB}

*Bob Dole {Sr. Managing Director at BlackRock}

*Dr. David Kelly {Chief Market Strategist at JP Morgan}

*Christopher C. Davis {Chairman of Davis Advisors}

Below are my notes, a few quotations, and a comment or two

All four men stated, unashamedly, that they expect to see the next ten years produce 8-10% inflation adjusted returns from equity holdings. In order to achieve this rate of return in an individuals portfolio they suggested being overweight equities, underweight bonds, and an acute focus on Emerging Markets {BRIC}

Davis argued that we're doing ourselves a huge disservice by staying in Money Market Accounts. He noted that the Perils of Passivity {being in a safe haven like cash} are essentially backward thinking. He equates cash to "The Returnless Risk", citing that in the lifespan of his father, the dollar has lost 92% of its purchasing power.

Kelly proposed that the idea of current massive volatility in the market becomes much more muted when you change the time period to a 10 year moving average. He said that historically speaking, current volatility is very average when viewed through this lens. His recommendation was, "have a plan, stick to it." I found it rather cliche and dull. Remember that the further out you take your volatility lens, the less muted weekly, monthly, even yearly events become. I expected deeper wisdom from a Ph. D in economics.

10 year moving average of the S&P yearly volatility. We're average right now, huh?

Applegate had a unique outlook for the near term. He mentioned the date December 1st. No one in the media has said a thing about this to my knowledge and he made a compelling argument. Obama's Committee on Deficits makes it official recommendation about how to fix our current situation. The only other time this type of committee has been around was during the Reagan years. The outcome of that committee was a change in the retiring entitlement age from 65 to 67. Applegate said that this will happen again and the result will result in pushing our debt further out the curve. The 'media' effect will say that our budget is looking much better and the stocks will continue to head higher. I don't have an opinion on whether this will happen or not, but it was interesting.

Here are a couple of  one-liners and some of the interesting correlations they cited though providing no actual data were:

*14% of disposable income went to debt servicing in 2000, now we only use 12.1%

*The largest component of Consumer Confidence is the Unemployment Rate

*Attractive P/E ratios are the precursor for gains in Consumer Confidence

*High Unemployment is the precursor of gains in future equity valuations

*QE2 is coming

*The Bush Administration Tax Cuts will be extended for at least 2 or 3 years

On the whole, it was an interesting night with some people that I would dub "perma-bulls." I was a touch disappointed that there were no contrarian viewpoints to their arguments, though I am sure that bearish comments where NOT what they were hired to talk about. I'll finish with a quote from Sir John Templeton that I'm sure they would have engraved on their desks. {especially knowing where we've just come from and where they believe we're headed}

"Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria."

What does everyone else know...

I noticed this headline today on ZeroHedge.com

NYSE Short Interest Surges To Second Highest In A Year In Advance Of September Short-Covering Rally

Here's the accompanying graph that can be found here.

I don't really have much to say about this with one exception. IF we do get some type of hint at QE2 AND we have a broad market rally, it will be greatly exacerbated by the rush to cover these shorts.Oh and good luck getting real volume done when the HFT turn off their algorithms.

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.

::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::
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

Summer is finally over

It was a summer filled with doldrums.

There were long stretches that I was on vacation. Ironically, there were even long periods where I should have been. The volume in our contracts was anemic and is just now beginning to pick up. Even so, I've found it increasingly difficult to regain my market feel. All of the moves have been one directional with virtually no two-way paper. It's hard to make a trade and then have to sit on a position for what seems like weeks just to see if the trend folds back around. The P of PnL has been tricky to come by, the L has been here frequently.

As my kids are now back in the saddle with school, so must I rejoin the ranks of the working. The plan will be to write at least twice a week. I want to outline the plays I think are worthy of a look and the discuss some of the thought process that we've put into out trading. I have been joined by a new accomplice from past life. And though I haven't figured out his moniker yet, his ideas have already permeated my thinking. Hopefully, he and Mr. Practical Thinker will start to contribute on a weekly/monthly basis. Their ideas are always fresh and thoroughly thought provoking.

In the next few days, I hope to put out a couple of our current positions as well as a few of our thoughts on what might come next.  

~LH