Issue 93: (Case Study) Step-by-Step Bond Trade Shared - Masters in Trading Digest

(Case Study) Step-by-Step Bond Trade Shared

An interesting trade discussion recently happened in our Futures Edge Discord room. I’d like to help interpret the information discussed for those not as familiar with this style of trading. Here’s the post:

July 18th, 2022 – Pablo Lucena Post

 /ZF options SKEW trade! —-

I've been looking for a new bond trade setup.

/ZF call options – the October (65 days) or November (95 days) expirations. These are 2-3 month trades, which I also like. 

The Fed is moving at unprecedented speed. The Bond market continues to show great relative value trade setups.  This is one of many reasons Pablo is “looking for a new Bond setup.”

Notice that we are starting to see the OTM calls cheapen relative to the equidistant OTM put.

This is “skew.”  When options are not priced fairly between puts and calls, they are considered skewed to one side.  

Let us use Biotechs as an example.  Many of these speculative names are skewed to the upside (calls are more expensive than puts) because traders prey on exponential upside movements so they buy out-of-the-money calls pushing prices higher than the same puts.

Since I still have the TLT put position on, adding this long /ZF call position makes sense for my portfolio.

Pablo must think /ZF is inexpensive relative to /ZB.  The TLT will be 99% correlated to /ZB Futures (Bond Futures).

Further Implications 

Based on this skew – and assuming our long call trade works (/ZF price rallies, yields drop) – this would mean that within the next 60-90 days, the Treasury market is expecting some form of shock. 

When traders expect shock, said another way – when traders expect uncertainty, the optimal trade is to get long volatility and buy options (calls and puts).

This aligns perfectly with what the Eurodollar curve tells us – the Fed will have to reverse action in late 2022 (roughly 90 days).

Referencing another portfolio position of Masters in Trading Futures traders.  Note – in our midyear Financial Summit, one of 3 trades shared was a six-month Eurodollar trade idea.

Don't let the fact that there is currently no OI on these expirations scare you. Markets are tight. The bid/ask spread is tradable on these 90-day/ZF options.

One of the more misunderstood parts of the options market.  You can buy an offer, and if there’s a bid, you can sell.  You do not need Open Interest in an options tree to make a trade. I would love to teach you more about this.

CJ Question – What Delta would you target for this trade?

Pablo Answer – Normally, this question would not be as relevant – but in this case, or whenever we're trading the skew, I try to snipe options where the price discrepancy vs. the calls (or puts) is most extreme. 

Why would calls be so much more expensive than puts?  What does the market know?  Find the strikes with the biggest difference, and there’s your trade.

Note that this is my main focus; next comes the practicality/probability of profitability.

I normally don't trade options this way unless it's for a skew trade. In non-skew trades, I optimize first for risk to reward and probability of profitability – since, for the most part, I'm trading direction of underlying or volatility increase (direction as well, vol up, vol down).

In skew trades, we introduce another “dimension” in addition to the direction and volatility component – the relative value of call options vs. put options. 

All things remaining equal (direction & volatility), we can also profit from having our originally cheaper /ZF call options start to get to par, or surpass, the equidistant put. 

So, I'd aim for the delta that expresses this point of view the most. I tend to start out with .25-.30, but this is not a hard rule.

July 22nd, 2022 – Pablo Lucena

Ok, by today this trade has to be green. Did anyone take this?

Then, he adds: When the skew trade presents, I partake.

[8:38 AM] Keith B: I took the ZF 113 call last week. expire October.  

Just covered my cost by selling a call.

Pablo teaches the Friday Breakdown Class each week. This class is available to all Masters in Trading Futures Members.

Masters in Trading Digest - Issue 93

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FINAL THOUGHTS

WHAT TO EXPECT IN THE NEXT MIT DIGEST

The next issue will be released on Wednesday. 

Until then, trade smart and always manage your tail risk.

Thanks for reading,
Jonathan Rose

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