How to Trade Bonds with Futures

Bonds are in play. The Federal Reserve is raising rates, inflation is roaring, geopolitical risks are expanding, markets are volatile, there is a wide divergence in experts’ economic forecasts and bonds are moving. What more could a trader ask for? Many traders’ initial reaction is: what’s the trade? Should I buy bond futures? Sell bond futures? With the current volatility in bonds, just trading bond futures outright long or short can be a recipe for disaster. You’re making a bet solely on direction and, if you’re wrong, you could lose a considerable amount of your capital, receive the dreaded margin call, or even blow up your account. Where’s your edge? You gain edge by trading Relative Value; a better approach to trading and managing risk. It is used by seasoned traders and a key principle in Masters in Trading approach to trading and actively discussed in Discord.

What Bonds are we Talking About

When we say bonds, we are talking about U.S. Treasury securities and their derivatives. Why Treasuries? Treasury markets are among the most liquid in the world, second only to foreign exchange. Liquidity is very important to a retail trader battling to find an edge. Liquid markets are characterized by many sellers and buyers, narrow bid/ask spreads, low transaction costs and longer trading hours. In liquid markets, retail traders can get in and out of positions relatively easily and at lower cost. Other bond products such as corporates or municipals do not share these characteristics; in fact, some securities/issues are so illiquid, they are said to “trade by appointment only.”

How Many Ways are there to Trade Bonds

There are a ton of ways to trade bonds. To be honest, you are only limited by your knowledge, experience, creativity, and capital. Here are a few ways you can get exposure to bonds:

• ETF’s – such as $TLT (the equivalent of a 20+ year Treasury)
• Options on ETF’s
• Futures – /ZT (2 year), /ZF (5 year), /ZN (10 year), /ZB (30 year) and /UB (Ultra)
• Options on Futures
• Some combination of the above

Each of the above instruments, used in isolation or in some combination will have its own risk/return characteristics and can be used to structure a trade to express your view or opinion and desired risk profile.  Let’s focus on futures.

Relative Value – The Underlying Approach to Trading

Relative Value is the underlying principle of Masters in Trading’s approach to finding, analyzing, and managing each and every trade. No security or product is cheap or expensive (or a good trade) on its own, in isolation. It is cheap or expensive relative to something else. For example, the 30-year bond future (/ZB) is not cheap or expensive on its own; it is cheap or expensive relative to other bond maturities across the yield curve such as the 10-year future (/ZN) or the Ultra future (/UB) or both.  One approach is to trade a bond butterfly. This relative value concept will drive the structure of the trade; long the relatively inexpensive bond(s) and short the expensive bond(s). This structure is not a bet on direction, but the relative movement of the futures involved. It is a more efficient use of capital by managing risk through a less volatile trade with more trade management opportunities. 

What is the Bond Butterfly Trade

Let’s focus on the /ZB fly. The /ZB fly (actually any bond butterfly) consists of 3 futures contracts of different maturities. In this case, the ZB is the body and the /ZN & /UB are the wings.  If you’re long the /ZB fly, you will be long the /ZB and short the /ZN & /UB. What if you’re short the /ZB fly? Right, you’re short the /ZB and long the /ZN & /UB. But what exactly are we trading?  We are trading the value of the /ZB relative to the value of the /ZN and /UB. If the /ZB is relatively expensive, we’ll short the fly; if it's relatively inexpensive, we’ll go long the fly. 

How To Analyze a Bond Fly

Although there is no perfect approach (it depends on your trade timeframe and risk profile), Masters in Trading suggests starting out with a wider timeframe, looking for consistency through shorter timeframes and using the shortest timeframe for trade entries. Using the Masters in Trading Edge Tools, let’s start with a wider view, the daily over the last 3 years and look at the /ZB fly vs. the /ZN fly (/ZN vs /ZT and /ZB) and what do you notice:

Look at how extended both flys are; the ZB fly is at its highest point in the last 3 years while the ZN fly is at its lowest point.  Also notice how the flys were extended about a year ago, in the red circle, and came back together, almost like a rubber band snapping (or visualize a dog running, getting to the end of its leash, and being yanked back) – this is the trade – extended then back together.  The ZB fly looks expensive, and the ZN fly looks inexpensive, so a potential trade is short the ZB fly and long the ZN fly. We see the same relative values as we focus on shorter and shorter timeframes.  For example, the March month-to- date looks very similar as both flys are extended:

The next step would be to zero in on shorter timeframes for entry points.

How To Start With a new Trade Strategy

Trading Relative Value takes some getting used to and there are some very technical aspects of the butterfly trade that are not covered here. Masters in Trading is great resource for further exploring the Relative Value concept, the bond butterfly and similar trades/related trades. Remember, trade size and money management are more important to a successful trade than your exact entry point!