In 1975, the Chicago Board of Trade (CBOT) introduced interest rate futures to meet a growing demand for products that could protect against fluctuations in the cost of borrowing money. Treasury bonds and later T-notes became the most liquid futures markets as banks, investment firms and private funds all used the Treasury products to hedge against movements in interest rates.
Yet, at a time when interest rates and the cost of borrowing are at the center of not only financial but mainstream news media, most individual investors know little about trading these markets, and even less about doing it successfully. Much of the information available is complex and meant for a sophisticated or institutional audience.
But what about the individual investor? With the Federal Reserve dominating daily headlines, and the average investor finding he has a vested interest in the credit markets (whether he knew it or not), Treasury futures are gaining popularity. It seems that some traders are starting to feel just as comfortable guessing Ben Bernanke’s next move as they are calculating soybean production estimates.
If you are intimidated by yield curves and basis points, don’t be. The fact is, you don’t have to dive into yield curve hedging strategies or explore rate inefficiencies with calculus that would make PIMCO’s Bill Gross proud. There is a strategy that allows you to profit from changes (or non-changes) in interest rates. The strategy is option selling. Here, we will demonstrate how to apply the option-selling strategy to T-bond futures — at a time when winds of change may be blowing at the Fed.
WHY OPTION SELLING
Option selling has become increasingly popular with investors in recent years. For a long time, the term “unlimited risk” was enough to scare most investors away from selling options, especially options on futures. But many are now realizing that this term can be misleading taken out of context and such a high percentage strategy should not be overlooked in a serious portfolio. The CME Group did a study a few years back that estimated that approximately 80% of options held through expiration will expire worthless. With today’s volatile markets, many investors are starting to believe this is a statistic they would like to see working to their advantage.
For most market participants, the hardest part of trading is trying to determine where the market is going to move and when. Option selling is a strategy that eliminates the need to predict when and where the market will move. In exchange for eliminating windfall gains, option selling offers smaller consistent gains over and over. While profits on each trade are limited, over time probabilities of success on each individual position are high.
To understand, consider selling options in terms of this football analogy: Most traders are busy trying to time the market, buying low and selling high. They are playing offense. They are trying to get the ball in the end zone. But scoring is hard. You can march down the field only to fumble on the one yard line. It takes exceptional skill, timing and discipline. Complicating matters, most traders don’t punt on the fourth down, preferring to go for it.
With option selling, you don’t have to make a big score. Option selling is similar to playing a prevent defense. You start the game with a few minutes left and a big lead. All you have to do is protect the goal line and run out the clock. You set your defenders back near the goal line and wait. The opposing team can do whatever it wants. As long as they are out of the end zone when the clock runs out, you win.
When you sell options, you do not have to decide whether the market is going up or down. You just need to decide where the market is not going to go. You select a price level above or below the market that you believe the market will not reach within a certain time period (generally within 60 to 90 days). You then sell an option at this price level and collect a premium for doing so. If the time period elapses and the market has not attained this price, the option expires and the investor who sold it keeps the premium as profit. If the market is trading at a level beyond the seller’s strike price, the option is in the money. In this situation, the option seller takes a loss.
There is a risk in this strategy that the option could move in the money, but the risk is no more than that of a futures contract. Just like insurance companies, option sellers have to pay out from time to time. But remember, insurance companies make hefty profits by collecting many premiums, but only paying out on a few claims. Option sellers bank on the same principle. You are not immune from drawdowns, but statistically, the majority of your trades should be winners.
FOLLOWING THE FED
With all of the recent focus on the Fed, the U.S. Treasuries have been more active. As many investors follow financial and economic news, many feel they know what the Fed is going to do and, thus, know how interest rate futures will react. For those of us without a crystal ball, however, option selling is a better way to take advantage of this market. For option sellers, it is only important where prices won’t go.
In deciding where prices will not go, it helps to have a little insight into the fundamentals that move the underlying market. In soybeans or cocoa, the fundamentals consist of supply and demand factors. In Treasury bonds and notes, supply and demand can play a role as well. For instance, there’s the amount of T-bills available for auction each week compared to how much sellers are willing to pay. The primary fundamental in interest rate futures, however, is interest rates.
The relationship between interest rates and Treasury futures prices is simple but many do not understand it. If interest rates are rising (or expected to rise), bonds and debt notes issued in the future will offer a higher yield. That means that the fixed income assets that these portfolios are currently holding will be worth less, because their yield is less. Thus, the value of existing Treasuries fall. Conversely, if interest rates are falling, or expected to fall, outstanding Treasuries will be worth more, as their yields will be higher than the new issues.
Treasury futures prices have an inverse relationship with yield. If yields (interest rates) are expected to fall, Treasury futures will typically rise. If yields are expected to rise, Treasury futures tend to fall. Thus, there is a plethora of economic news that can move Treasury futures in the short-term and how investors and hedgers perceive the news could affect interest rates.
While this can result in sharp short-term fluctuations, the longer-term direction of Treasuries should be dictated by the longer-term trend in interest rates. As we discussed in “The Complete Guide to Option Selling,” a market with clear longer-term fundamentals and short-term volatility can be an excellent candidate for option selling.
TRADING STRATEGY
Many traders and economists feel that the round of rate cuts during the spring of 2008 will be the last for awhile. While short-term prices can fluctuate, bonds should have a hard time staging a substantial rally if the economy shows any signs of improvement or if the Fed “throws in the towel” on rate cuts.
Further, there is a growing school of thought that if commodity prices continue to increase, the Fed will be forced to abandon its rate cutting strategy and possibly even begin raising rates to fight inflation (see “The gig is up”). With gasoline above $4 per gallon in many locations, such policy change is likely.
A pause in rate cuts would be moderately bearish for bonds, and should the Fed raise rates later this year, it would be quite bearish. Either way, it should be difficult for bonds to stage a substantial rally unless the Fed embarks on another wave of rate cuts, a course increasingly unlikely.
If you are in this camp, selling calls in T-bond futures may be the right strategy for you. Rather than sell the futures and hope you don’t get stopped out on a technical rally, selling calls high above the market would be a higher probability strategy.
Assume that in June 2008, an investor feels that the Fed is done cutting interest rates for the year. Rather than try to outguess the short-term factors driving prices, the investor takes a longer term, higher percentage position by selling T-bond calls (see “High above bonds”).
Underlying market: December T-bond futures (CBOT) Strike price/option: 124 call
Premium: 26/64 (26 x $15.625 = $406.25)
Margin requirement: Approximately $1,100
Expiration: Nov. 21, 2008
Rather than buying a put below the market hoping it moves down sharply before the option expires, a more prudent decision is to sell a December T-bond 128 call for a premium of $406.25. T-bond options are priced in 64ths, so every point is worth $15.625. Thus, this option could have been sold for 26 points, or $406.26.
The trader will have to put up margin to hold this position. For this example, the margin would be about $1,100. In other words, he would have to invest $1,100 to be held as deposit for as long as he is in the position. Should the option expire worthless, the investor would receive his deposit (margin) back and would also keep the $406.25 premium he collected.
The option seller does not require the market to make a big move to profit. The idea is for the option to expire worthless, which it will if the strike price has not been reached by expiration. Therefore, unlike the option buyer, the seller can profit if the underlying market moves in his favor, remains steady or even if the market moves moderately against his position. As the option nears expiration, it becomes more difficult for the option to gain in value, thus benefiting the option seller. In the case above, as long as December T-bonds remain anywhere below 124, the option will expire worthless.
The risk to the seller is that the underlying market price moves beyond the strike price of the option. In this example, if the T-bond futures price moved above the 124 strike price and the holder of the short option does not exit, losses can continue to accumulate as if the seller were short a futures contract at 124. This is where the term “unlimited risk” comes from. However, just as the short futures position holder, the option seller can control this risk by exiting the position.
Other risk-management strategies include using stop orders (available in some markets) or writing covered options — also known as credit spreads — for the more conservative investor.
Both of these scenarios assume that the option is held through expiration. However, options can be bought or sold any time prior to expiration. Thus, an option seller can choose to exit the position by buying out of it at the going market price. This could be done at a profit, or it could be done at a loss, depending on what is happening with the underlying market and how much time is left until expiration. If most of the value of a short option position can be realized by buying the option back at a lower price, it makes sense to take the profit and apply the margin to the next opportunity. There is so much economic data available that influences financial markets that it is difficult to track on a daily or even weekly basis. However, with the Fed running out of room to cut rates and inflation rearing its ugly head, the longer-term trend could be down for bonds. Call sellers applying the above strategy would fare well in such a scenario.
James Cordier and Michael Gross are portfolio managers with Liberty Trading Group/OptionSellers.com and are the authors of the book “The Complete Guide to Option Selling” (McGraw-Hill 2005). They can be reached at www.OptionSellers.com.
