wmeubank@ocp.kcmo.com
A GOOD TIME TO BE BULLISH
ON BONDS AND VOLATILITY
Prepared by Jack McIntyre
Strategy
Buy the September 113 calls on the September T-bond contract. Target the underlying to the 115 area. These options are currently trading near 1-20/64. If the underlying contract trades to 115 by the end of July these options should be worth 2-14/64 (not assuming an increase in ivols).
One thing which was recently brought to our attention is that July has become one of the more volatile months for the bond market over the last four years. The average price range since 1993 is 4.71 points which is followed by September's 4.64 average as well as August's 4.46 average point range. It also happens that since 1993, July is becoming one of the best months for bonds. The average percentage price change in futures since 1993 is 1.33%, which ties January as being the best performing month for the bond market.
How should you take advantage of a month which is normally bullish for bonds while at the same time typically experiences a wide trading range. The answer is...OTM T-bond call options. Buy them. They are relatively cheap and certainly do not fully reflect the potential for the market to rally this month. We expect that volatility in the front-end of the U.S. curve is going to diminish as the Fed stays on hold for the rest of the year. The 2-year on in, sector of the curve should trade more in a range which in turn should drive volatility premiums lower in the front- end (or keep them stagnant). However, we would be buyers of volatility further out the curve.
Reasons that actual volatility could pick up this month include the following. One, the typical summer slowdown. A lot of traders take vacations during July and trading volume typically runs below average. This means that it may not take as much "size" to move the market. Secondly, the Fed is active this month. Both in terms of the FOMC meeting, but more importantly due to the Humphrey-Hawkins testimony which occurs near the end of the month.
Reasons that bonds could trade higher: 1. A favorable global environment for bonds. 2. An inactive Fed keeps the market focused on the upcoming H-H testimony as well as the August FOMC meeting. 3. Technicals still favorable. 4. Positions are mostly balanced (market is not leaning strongly one way or the other). 5. The CRB. 6. Sentiment is still holding onto a bearish tone. Markets hurt the most people.
Bottom line, it is a good time to be bullish on bonds directionally, but also bullish on volatility.
July 3, 1997 MCM, Inc.
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