| Anatomy of a Long Volatility Put Option Trade in the Treasuries |
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| Wednesday, 24 March 2010 11:45 |
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Normally, I eschew option trades as a rule. The primary reason is that I simply don’t like to think like an options trader, it typically bores the living crap out of me. Another reason I do not like options is that I am usually a buyer, speculating on direction and timing.
However, the reason for considering an options trade strategy in the long term treasuries has been two-fold. First, there is a real potential for explosive job growth on the April 2nd NFP report. Such an event can bring out the bond vigilantes in full force and vols will increase. If so, treasury prices should take a big hit as it happened on the April 2 2004 NFP report six years ago. If the April 2 2010 NFP report does not show explosive job growth or fails to bring out the best of the bond vigilantes, I will be exposed and caught naked long May puts on April 2nd that expire 21 calendar days later April 23. There is little much room for error in judgment on this trade. It should be noted that the whole concept for this trade originated from the economists forecasts for the April 2 NFP report to show 275,000 or more jobs being created in March 2010. Those forecasts became known on the week of March 8, two weeks ago. Since those initial forecasts by Jan Hatzius and others, the consensus forecast has been whittled down to +150,000, still a substantial amount, that leaves room for the upside risks cited by Hatzius and others. With upside risks to the forecast, a price shock on the downside is even possible. The strategizing for this trade began March 9, I only began putting on the trades March 19 and March 22-23. I like to give myself plenty of room for error. This May put option trade is a bit more aggressive than a normal trade for me as the short time does not give me much flexibility for errors in judgment. As always with speculative biased trades, getting location and timing right is essential. But so to is getting the analysis right! If there is any hope of getting the location and timing right, the analysis had better be spot on. To compensate for potential errors in judgment, I always trade in small sizes. Potential errors in judgment that I can make relate to
Second, treasuries have been in a “box” or sideways trading range since June 2009. The 10 yr treasury has traded in a 7.13 point range and the 30 year has traded in 10.14 point range since June 2009. When markets find themselves in a box, implied vols collapse. That is what has happened in the treasuries over the past year. When implied vols collapse, options can be a better tool than futures, but futures remain my preferred vehicle of choice 99.9% of the time. Implied vols for at the money May 117 ten year note puts on March 22 with 32 days to expiration is at 5.5%. At the money May 118 thirty year bond puts with 32 days to expiry implied vols are 8.6%. The knock about being in a trading range or box is we have no idea when the mkt will breakout of its congestion, or its direction. Were it not for the well advertised or telegraphed expectation of a huge spike in the April 2 NFP report, I would not have even been considering this trade strategy. As noted above, options are a more suitable tool than futures for this low volatility, trading range environment. I chose a bearish directional bias based on my observational knowledge and on upcoming economic forecasts pertaining to the April NFP report (and less important others).
Knowing that options might be the best tool solved only one part of the problem. I also had to choose which treasury puts to buy (not just the strikes), but also which contract, the 10 or the 30 year. Many assume the 30 year is always the best product choice for going long vols and that is generally a valid belief. But this was not so clear to me as I considered the trades. I chose a combination of May 10 and 30 year puts for the following reasons. 1)I bought the May 30 yr 114 puts on the mkt strength it displayed on Friday March 19. 2)Conversely, the 10 year had exhibited more strength on Monday and Tuesday March 22-23, hence, I found it easier to buy 10 yr puts on March 22-23. Now, I initially had to tread cautiously because I had no validation that the treasuries would only double top on last week’s March 17-18 FOMC and CPI high. It is important to note that even though I observed bearish signals (outside down day in the 10 yr and dark cloud cover in the 30 yr) on this key March 18 date, I did not just assume that the market would confirm these bearish signals as I established my position. Thus, I moved slowly and cautiously into this trade. I work hard Not to assume my personal beliefs and biases will be validated and confirmed by the mkt. I assume the trades I am putting on might be or will be wrong. This is key to controlling risk. I do not put a stop in and hope and pray the trade does not go against me. Even if the mkt does move in the directional bias as expected, playing aggressive defense throughout the trade campaign is extremely important. Even more so when long options! Risk control, in the final analysis is all that matters. Checking the Option Strike Chart
See the note I wrote in two of the three option window panes above. As I considered how to put the trades on, I worked on the assumption that the treasuries topped on the bearish reversal signal on the March 18 2010 CPI report one day following the March 17 FOMC meeting. I also worked on the assumption that the week of March 22 would be a double top of sorts. This led me to believe that with time decay, the May put options would trade below the lows they set on March 17-19. The confidence factor that the March 18 2010 bearish reversal signal on the CPI report a day following the March 17 FOMC meeting would be validated was enhanced by the high set six years ago on March 17 2004 CPI report one day following the FOMC meeting. In March 2004, the 10 and 30 year treasuries double topped on Wednesday March 24 2004, one week after the high set on the March 17 2004 CPI report one day following the March 16 FOMC meeting (shown below).
As you can see from the chart above, there was a substantial price shock on the April 2 2004 NFP report which showed 353,000 jobs were created in March of that year and the economists only forecasted 100,000 jobs being created that month. So, if I suspected the treasuries were going to double top this week and put in a secondary high, I had to at least assume that the options will trade to lower lows the week of March 22. That did not happen. For that reason, I cautiously nibbled on March 19, 22, and 23 at or near the lowest option prices set on Thursday March 18. Because I am a huge believer of buying or selling outside established ranges, I was trying to establish a larger put option position at lower lows. I was able to establish about half the position size I wanted just buying the lower extremes of last week this week. On this morning’s volatility spike, I did sell the 30 yr May 115 puts. I will cover all puts on the April 2 NFP report. Ideally, some upside risks to the economists’ forecast will be realized prompting a price shock to the downside as occurred six years ago on the April 2 NFP report. With or without the price shock, the trade gets covered on the April 2 NFP report. } Georgia Anderson` Financial News Network, trader, trader education, online forex, daytrader,forex currency, forex software, investors, forex trading, forex. |
Disclaimer
There is substantial risk of loss in trading commodity futures, options and off-exchange foreign currency products. Each investor must consider whether this is a suitable investment.
Trades or trade recommendations made on this site have not been made by Georgia Anderson.
Trades or trade recommendations made on this site have not been made by Georgia Anderson.
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