Treasury Options for Capitalizing on Event Risk

By Keith Schap   ISSUE 301 | JAN 2004

When you think the market consensus on an economic report such as the employment number or an anticipated Federal Reserve policy shift is wrong, you can buy an option on CBOT Treasury futures to express your opinion. Of course, when the consensus proves to have been on target, no trading opportunity will emerge. Nevertheless, shrewdly planned option trades risk relatively little capital, but can result in significant gains.

Evaluating Event Potential

To see when trades of this kind might be appropriate and how they might work, consider the Treasury market leading up to and immediately after the June 25, 2003 meeting of the Federal Open Markets Committee.

In the weeks prior to June 25, street talk held that the Fed needed to lower its fed funds target 50 basis points (bps), from 1.25 percent to 0.75 percent. At least the street was hoping for a change of this magnitude. The shift in the Treasury yield curve from May 27 to June 24 shows that much of this had been priced in, as Exhibit 1 illustrates. During this period, 10-year Treasury note futures rallied from 117-31 to 119-08.

Exhibit 1: The Treasury Yield Curve Shows that the Market Anticipates a Fed Ease
Maturity	5/27/03 Yields	6/24/03 Yields	Change
2-year	1.32	1.10	-0.22
5-year	2.35	2.15	-0.20
10-year	3.43	3.25	-0.18

Yet, as the day of the meeting drew near, the fed funds futures market motivated reasonable doubt concerning the 50 bp target shift. As a Fed meeting approaches, analysts can feed current fed funds futures prices into a simple either/or probability equation to assign probabilities to possible Fed policy shifts. These analysts can set up the math to decide how likely the Fed is to do nothing or to shift its fed funds target rate 25 bps. They can also use the math, as in this case, to decide what the probabilities are for either a 25 bp or a 50 bp shift. Exhibit 2 shows the probabilities that the futures prices implied for the five trading days immediately prior to the Fed meeting. Clearly, other than on June 19, the market was on the fence concerning whether the Fed would ease 25 bps or 50 bps. Despite this evidence, the preponderance of street talk was that the Fed would lower its target 50 bps.

Exhibit 2: Fed Funds Show a Market Evenly Divided on How Much Ease
Date	Probability of a 25 bp Ease	Probability of a 50 bp Ease
June 18	0.58	0.42
June 19	0.34	0.66
June 20	0.48	0.52
June 23	0.48	0.52
June 24	0.48	0.52

When the market gets something other than what it expects, interest rates often move quickly to reflect the new reality. Thus when the Fed eases 25 bps rather than the hoped for 50 bps, yields will rise quickly. In fact, the yield bounce might be a hefty one if, as often happens, the market overreacts. Because rising yields mean falling prices, one way to trade this would be to buy a put option, which tends to gain value as prices fall.

Choosing a Put

In planning a trade of this kind, it often pays to trade an option that is relatively close to expiration and that has a delta in the 0.20 to 0.30 range. A shorter-dated out-of-the-money option will cost less and generate a better percent gain if market events are as expected, or a smaller loss if events don’t play out as expected.

On June 24, both the August serial expiration and the September quarterly expiration were available. With September 10-year Treasury note futures trading at 119-08, 60 days to expiration, and implied volatility at 7.1 percent, the September put prices and deltas would have been as shown in Exhibit 3a. With the August option 33 days from expiration and trading at 7.5 percent implied volatility, the August put prices and deltas would have been as shown in Exhibit 3b.

Exhibit 3a: September Expiration Put Prices and Deltas
Strike Price	Put Price (in 64ths)	Put Price (in $)	Put Delta
119	80	1,250.000	-0.46
118	53	828.125	-0.35
117	33	515.625	-0.25

Exhibit 3b: August Expiration Put Prices and Deltas
Strike Price	Put Price (in 64ths)	Put Price (in $)	Put Delta
119	61	953.125	-0.46
118	36	562.500	-0.30
117	19	296.875	-0.20

Based on the time to expiration and delta rules of thumb, the September 117 put and the August 118 and 117 puts are the possible candidates. Based on how much trading capital each of these three possibilities will put at risk, you might prefer the August 117 put in this case.

Evaluating Results

In the actual case, the Fed lowered its fed funds target 25 bps on June 25, and Exhibit 4 shows how the market reacted (or overreacted), in terms of how the Treasury yield curve shifted from June 24 to June 26.

Exhibit 4: The Market Expresses Displeasure with the Size of the Fed Move
Maturity	6/24/03 Yields	6/26/03 Yields	Change
2-year	1.10	1.39	0.29
5-year	2.15	2.44	0.29
10-year	3.25	3.52	0.27

Because of this 27 bp move in the 10-year yield, 10-year Treasury note futures prices dropped from 119-08 on June 24 to 117-06 on June 26. Curiously, implied volatilities didn’t react to the change. Exhibits 5a and 5b show how the September and August options would have performed based on this futures price change and no shift in implied volatility.

Exhibit 5a: September Puts Generate Significant Gains
Strike Price	June 26 Put Price (in 64ths)	Gain or Loss (in 64ths)	(in $)	Percent Change
119	156	76	1,187.50	95
118	113	60	937.50	113
117	79	46	718.75	139

Exhibit 5b: August Puts Outperform on a Percent Change Basis
Strike Price	June 26 Put Price (in 64ths)	Gain or Loss (in 64ths)	(in $)	Percent Change
119	139	78	1218.75	128
118	95	59	921.88	164
117	59	40	625.00	211

You can see that if you had bought the August 117 put on June 24 for 19/64 and sold it on June 26 for 59/64, you would have gained 40/64, or $625 an option. You will have risked slightly under $300 to earn $625.

This kind of short-term event trade can produce satisfying results. However, notice that if you had entered into a trade like this before the August, September, or October 2003 Fed meetings, the options would have gained little or nothing. The most likely result would have been to have lost the price paid for the options, although that would have been the limit of the loss, excluding fees and commissions. It is also true that no one expected any Fed action at those meetings, and there was no reason to make the trade. Trades of this kind are only appropriate when you have reason to believe the market consensus is wrong.

Keith Schap is a Senior Writer in Business Development at the Chicago Board of Trade.

Laura Oatney is editor of LindForum. She can be reached at editor@Lind-Waldock.com.

Futures trading and options on futures trading involve a substantial risk of loss, including more than the original investment, and thus may not be suitable for all investors.

The information in this publication is taken from sources believed to be reliable. However, it is intended for purposes of information and education only and is not guaranteed by the Chicago Board of Trade as to accuracy, completeness, nor any trading result, and does not constitute trading advice or constitute a solicitation of the purchase or sale of any futures or options. The Rules and Regulations of the Chicago Board of Trade should be consulted as the authoritative source on all current contract specifications and regulations.

© 2004 Lind-Waldock, A Division of Man Financial Inc. All Rights Reserved. Futures Trading Involves Risk of Loss.