wmeubank@ocp.kcmo.com
A TEST OF 6% YIELDS ON THE
MARCH T-BOND CONTRACT
Prepared by Jack McIntyre
Strategy
Buy the January 119/117 put spread on the March 98 T-bond contract. Current price 58/64. Break even is 118-03. Maximum profit is 1-06/64. There are 26 days until expiration. Stop out this position on a close above 120 in the underlying (which would put the cash yield below 6%).
We are going to start off by saying that the Treasury market has yet to do anything wrong and that today's trade idea is a high risk trade. However, along with that level of high risk is high return so you should be adequately compensated for establishing this type of trade.
There are a couple of things which got our attention with the T-bond contract. Most come from its underlying technical picture. We'll overweight the contract's technical structure because there really are no major reports due out until the next employment report which is not until December 5th. Therefore, bond traders could place more emphasis on the contract's price action and technical picture.
It certainly is no surprise that the December T-bond is trending bullishly. In fact, it has since October 23rd. However, according to our trend work, the current bullish trend is getting to be mature. One measure of the trend is ADX (Average Directional Movement indicator), is registering a signal which is as high as it has been since April 14th of this year (when bonds put in a major bottom) and December 3rd of last year (when bonds put in a major top). This factor has us a little concerned and suggests that the most of the bullish move is probably behind us. We'll also be the first to admit that the market can continue to trend higher which is the major risk to bearish positions at these levels. However, with 30-year yields hovering near 6% which is one of those key psychological levels, it may make sense for the market to pull back from these levels. Often this is the case as traders and fund managers typically need major new news to get through these type levels. This time round should not be any different and since there is not major economic releases on the immediate horizon and the stock market is in a recovery mode (if not set to retest the recent highs). We'll also throw in the fact that the front-end of the curve is not providing any leadership in this latest rally. In fact, the March 98 Eurodollar contract is no longer trading within a bullish trend (although it continues to have a bullish bias), which may be a very early caution flag.
We would view this trade as having a shorter-term outlook than most of our other trades. This is simply due to the fact that even if the market “corrects” from current levels, we are not sure how deep pull back will be or how long it will last.
Implied volatilities for bond options are declining which is a function of the trending nature of the Treasury market. This is why we favor buying put spreads as opposed to outright put options. Even though ivols are declining, they continue to be fairly expensive at their current levels (mid-8%). Alternatively, and a slightly more risky option strategy involves selling OTM call options. In this case either the Jan 120 or Jan 119 calls on the March 98 T-bond contract.
November 21, 1997 MCM, Inc.
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