how big money trades session 6 – fixed income...u.s. government required disclaimer – commodity...

How Big Money Trades Session 6 – Fixed Income:

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Disclaimer

U.S. Government Required Disclaimer – Commodity Futures Trading CommissionFutures and Options trading has large potential rewards, but also large potential risk. You must be aware of the risks and be willing to accept them in order to invest in the futures and options markets. Do not trade with money you cannot afford to lose. This is neither a solicitation nor an offer to Buy/Sell securities or options. No representations are being made that any account will or is likely to achieve profits or losses similar to those discussed in this workshop or in any products or services. The past performance of any trading system or methodology is not necessarily indicative of future results.

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Disclaimer (Continued)

Anyone trading options on securities should view the Options Clearing Corporation's Options Disclosure Document (ODD) at https://www.theocc.com/about/publications/character-risks.jsp? Prior to trading options on any security.

All trades, patterns, charts, systems, trading strategies, etc., discussed in this workshop and the product materials are for illustrative and educational purposes only and not to be construed as specific advisory recommendations. No system or methodology has ever been developed that can guarantee profits or ensure freedom from losses. No representations or implications is being made that using $harpeCoach products, services, or trading systems will generate profits or ensure freedom from losses.

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https://www.theocc.com/about/publications/character-risks.jsp?


Investments or strategies mentioned in this workshop, including any handouts, may not be suitable for you. This material does not take into account your particular investment objectives, financial situation, or needs and is not intended as recommendations appropriate for you. You must make an independent decision regarding investment or strategies mentioned in this workshop, including any of the handouts. Before acting on information in this workshop, you should consider whether it is suitable for your particular circumstances and strongly consider advice from your own financial or investment adviser. Investors should be aware of potential risks involving options trading, including losses beyond 100% of capital invested, and are advised to consult with an investment professional.

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Terms of Use: Your use of these educational materials indicates your acceptance of these disclaimers. In addition, you agree to hold harmless, Charles Whitman, SharpeCoach LLC and Whitman Asset Management LLC, Dominic Boire, DGB Investing Inc, Van Tharp, International Institute of Trading Mastery Inc, Van Tharp Institute, Bruce Walicek, Gary Sundlund, Brad Koeppen, Michael Moskow, Guest Speakers, and Radian Capital Advisors, personally and collectively for any losses of capital, if any, that may result from the use of the information.

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Today’s Objectives:

Review Systems Thinking

Introduce Fixed Income Market Structure

Roles and Strategies of 4 Market Participants within Fixed Income Markets

7 Edges of Big Money Traders within Fixed Income Markets

Group Discussions and Debrief

Guest Speaker – Bryan Hou

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How Big Money Trades Section Review of Systems Thinking

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Systems Involved in Making a Trade and Determining its Outcome

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1. The Universal Human Game1. There is a way things should be and if things are not that way,

then there is something wrong with you, them, it, me, etc. that needs to be fixed.

2. You as a system1. Emotions 2. Beliefs3. Strategies4. Parts5. How you feel?/Energy6. Health7. Values/purpose

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3. Trading systems filters, entry, stop, exit, re-entry

4. Position sizing algorithm to meet your objectives

5. Market Type (up, down, sideways, under quiet and volatile conditions.

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6. Your underlying base currency. Here is what’s happened to the US dollar in the last six months. (What the Central Bank Does)

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7. Factors that influence the market environment. Pandemic (Covid 19) Trade War Political Election Those in Power

8. Regulatory Environment Market is Open/Closed Options/derivatives Margin

9. Ease of Trading Market manipulation easy or hard. Can short or not? Taxes Government perception of tradersCop

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10.Power Games How to biggest companies related/control government How to big investment banks influence trading/market making/and

fiscal policy.

11. Time frame traded. The smaller the time frame the less influences some of the other types

of systems will impact you, but the more impact the “You” variable will have.

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12.How Commercials (Big Money 1) Plays the Game (cont’d). Commercial is hedging and doesn’t consider the direction of the market.• Natural Long - company that produces stock, what a company or

producer produces (oil, grains, gold, etc.)• Natural Short – those who need the product (so they are naturally short

and they have to buy it at some point)• Commercial value changes from day to day. Right 90% of the time• Must know their objectives

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13. How Large Speculators (Big Money 2) Play the game (Trend following; Huge size (get in and out when they can); growth which is similar to trend following What are objectives? Frequency trader/Momentum/ Asset allocation with long term view.

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14.How Market Makers (Big Money 3) Plays the Game. These traders are like commercials but have a much smaller time frame. Driven by order flow. Vig (what is wagered vs what is won). Line = fair value. Line (fair value) is moved by supply and demand. Broker’s job is to balance the book, and not to predict who will win. Market Maker will get positive reversion to mean. Market Maker moves prices against himself and he cannot have an ego about

fair value.Dark Pools are a form of market maker/specialist. He will have a map showing (in the pool) where are the buyers and sellers are. 40% of orders for equities are in dark pools.Market makers trade relationships to lay off risk. Must have lots of ways to pay off the risk (=bigger markets). Football bet is small because not a lot of ways to lay off risk; e-mini is huge because many ways to lay off risk.Cop

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15.How small speculator trades (this is not big money) but it’s important to know because they will be net losers. Will do everything wrong. Motived by greed. I can retire now. Make money with friends.

Will not exit when the market is far from fair value. Doesn’t understand anything about systems thinking. May not have trading

system and certainly doesn’t understand the impact of market type or using position sizing to meet their objectives.

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How Big Money Trades Section Session 6:

Introduce Fixed Income Market Structure

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Introduce Fixed Income Market Structure - Objective

Understand Market Structure for Fixed Income

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Introduce Fixed Income Market Structure and Thoughts

Market Size for Fixed Income is Massive.– World Global Stock Capitalization = $90 Trillion (Dec 26, 2019)– World Global Debt = $255 Trillion (end of 2019)

• World Government Debt = $70 Trillion

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Market Size for Fixed Income is Massive.– Notional Value of Equities vs. Fixed Income

• World Global Stock Capitalization = $90 Trillion (Dec 26, 2019)• World Global Debt = $255 Trillion (end of 2019)

– World Government Debt = $70 Trillion

– Daily Notional Volume Equities vs. Fixed Income• US Notional Equity Volume = $250B/per day• US Treasury Average Daily Volume = $265B/per day• CME Eurodollar Average Daily Volume = $2T/per day• Daily Repo Notional Value = $2T-$4T/per day

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Fixed Income Markets are the most complicated of all asset classes. As a result, fixed-income instruments trade in dealer-oriented over-the-counter (OTC) search markets that differ significantly from other asset classes such as equities and FX.

The concept of a bond is simple, but each bond is unique in its terms. This makes standardization difficult. There are numerous bonds all with different maturity dates and different rates.

Treasury securities issued by central governments are in many ways the simplest fixed-income instruments, characterized by low default risk, high trading volumes, standardized contracts, and generally liquid markets. These markets are primarily electronic

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Access is more limited than other markets. This market is dominated by professionals and has the smallest retail presence of all asset classes

Although there has been some electronification of fixed income asset class, a great deal of the trade is still OTC and done via relationships. The sheer number of bonds plus structured products created with these bonds makes electronification difficult

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Fixed Income has been the asset class to have the slowest transition to electronic

Non-treasury fixed income is executed largely via telephone with indicative pricing– Indicative Pricing – a quote that is non-binding

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Fixed Income Markets are a combination of:– Exchange Traded (Futures, ETF’s, Basic Spreads, Basic cash bonds)– Over The Counter (OTC)

• Exchange Traded• Bilateral

– Foreign Government Bonds– Interest Rate Swaps– CDS– Corporate Bonds,– Municipal Bonds– Mortgage Backed Securities (MBS)– Structured Products

» Collateralized Debt Obligations (CDO)» Asset Backed Securities (ABS)

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Interest Rate Swaps– What is a Swap?

• A swap is a derivative contract through which two parties exchange the cash flows or liabilities from two different financial instruments

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Credit Default Swaps– What is a Credit Default Swap (CDS)?

• a financial derivative or contract that allows an investor to "swap" or offset his or her credit risk with that of another investor

• Acts like bankruptcy insurance – the purchaser gets bankruptcy coverage, and the seller gets premiums paid for the period of coverage. Like homeowner insurance in premise.

• Made famous in the book and movie "The Big Short" by Michael Lewis

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Structured Products In addition, fixed-income markets trade structured products, which are

created by repackaging existing loans.

Structured Products are most used in fixed-income market. They are primarily created by repackaging existing loans. Examples include:– Mortgage-backed securities (MBS)

• Agency MBS – implicit backing of semi-government agencies• Private Label MBS - no backing

– Asset-backed securities (ABS) - secured by packaged assets such as auto loans or credit card debt.

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Fixed Income is largely conducted with bi-lateral credit – credit agreements between 2 counter parties– Banks want bi-lateral credit transactions because it limits competition

–Bi-lateral is more capital intensive and lower access because relationship driven requiring an ISDA

• ISDA - An ISDA Master Agreement is the standard document regularly used to govern over-the-counter derivatives transactions. The agreement, which is published by the International Swaps and Derivatives Association (ISDA), outlines the terms to be applied to a derivatives transaction between two pars, typically a derivatives dealer and a counterparty. The ISDA Master Agreement itself is standard, but it is accompanied by a customized schedule and sometimes a credit support annex, both of which are signed by the two parties in a given transaction.

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Fixed Income market is much more of an institutional market. Most segments of the fixed income market have little to no retail presence

As a result, trade sizes are much larger than other examples. For example, trade sizes and frequencies differ dramatically across equity and bond markets. – median trade size in equity markets is 100 shares (O’Hara and Ye

(2014)), or approximately $3,000 to $5,000 for typically priced stocks. By comparison, a “round-lot” trade in corporate bond markets = $1 million.• Bessembinder et al. (2018) report an average trade size of $1.2

million for their sample of corporate bond trades from 2014–2016• Round lot transactions (increments of $1M), and Bessembinder

accounted for nearly 90% of corporate bond dollar trading volume. Most fixed-income products trade infrequently.

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Liquidity in most Fixed-Income segments is extremely low relative to other asset classes.– For example, Bessembinder et al. (2013) report that the majority of MBS

and ABS (e.g., credit cards and auto loans) in their 21-month sample never traded at all.

– One reason that individual corporate bonds trade less frequently than equities is that an issuer often has multiple bond issues outstanding. Although equity shares issued at different points in time by a given firm are fully substitutable, each bond issue is a distinct contract with differing promised payments, maturity dates, and priority in case of default, and is therefore traded separately.

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For the retail trader, the focus should be on centrally cleared, Government securities (Treasury securities, European/Asian Bonds), Fixed Income ETF's (SHY, IEF, TLT, LQD, HYG, JNK, MUB, MBB), Fixed Income Mutual Funds and Closed End Funds where there is price transparency and liquidity

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– Electronic Platforms for Fixed Income

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How Big Money Trades Session 6:

Roles and Strategies of 4 Market Participants within

Fixed Income Markets

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Roles and Strategies of 4 Market Participants within Fixed Income Markets - Objectives

Go over who the 4 market participants are within the Fixed Income markets.

Go over the strategies the 4 market participants are using within the Fixed Income markets

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4 Market Participants:1. Commercials2. Large Speculators3. Retail Investors4. Market Makers

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Commercial: Natural Longs are:

– Governments– Corporations

Natural Shorts are:– Central Banks (Federal Reserve)– Pension Funds– Insurance Companies

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Commercial: Natural Longs (Continued):

– Governments:• are the big natural long.• are natural longs because they need to sell bonds to borrow money.

They pay interest in return for borrowing money.• borrow money to smooth inflows from mismatches in timing of tax

payments.• tend to push the limit of what they can borrow (deficit spending) so

they can appeal to their populace. Most eventually default on their debt and even the ones who don't have scares that fear that consequence.

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– Corporations:• are natural longs as they are sellers of bonds to the market• borrow money to fund expansion and manage mismatches in

payments.

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– Corporations:

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Top 10 Largest Corporate Borrowers1- AT&T, $151 billion2- SoftBank, $110 billion3- Pemex, $106 billion4- Comcast, $103 billion5- Anheuser-Busch InBev, $102 billion6- Ford Motor Company, $101 billion7- Verizon, $101 billion8- Apple, $92 billion9- General Electric, $91 billion10- Evergrande Group, $81 billionCo

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Commercial: Natural Shorts (Continued):

– In the natural short category for Fixed Income, I think about the objectives of the participants. I think what is common amongst these participants is that they are making investments that they have no exit planned.

– Central Banks have the objective of creating and managing the monetary base. They will buy securities, but they don’t necessarily have a plan to sell out in less there is a change in monetary strategy.

– Pension Funds and Insurance companies are purchasing fixed income securities with the intention of holding them for yield. This often leads to holding to maturity to limit transaction costs and turnover.

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– Central Banks:• are natural shorts.• buy government securities as a means of injecting money into the system.• can also be sellers when they want to tighten money supply.• make money when they purchase securities because they receive interest

on their purchases.• are often buyers of last resort, & tend to buy securities at favorable prices

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Commercial: Natural Shorts (Continued): Central Banks – Federal Reserve

– Most investors lack understanding of what the Federal Reserve does. The Fed is responsible for:1. Monetary Policy (size and stability of the monetary base)2. Interest Rate Targeting and interest rate guidance3. Oversight of banks in the banking system and regulation

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Commercial: Natural Shorts (Continued): Central Banks – Federal Reserve:

– Monetary Policy (size and stability of the monetary base)• Fed influences the Monetary Base through 3 methods:

1. Purchasing/Selling Securities2. Adjusting Reserve requirements3. Special Facilities

» Special Facilities are usually about liquidity or short-term purchases such as buying T-Bills

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– Interest Rate Targeting and interest rate guidance• Fed sets rates via the Fed Funds Rate and Discount Rate• Fed Funds Rate – rate that banks loan to each other (doesn’t always happen)• Discount Rate – rate that banks borrow directly from the Fed• Interest Rate Guidance – by giving forward guidance on rate expectations, it

projects a plan to the banks and the economy about expectations that can give banks additional confidence to make loans

• Oversight of banks in the banking system and regulation45

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– The Fed can create money and use the money to buy securities directly from banks. The cash from these purchases end up as assets on the bank’s balance sheets which it can turn around and lend this cash out levered.• The maximum leverage ratio is 24:1 for large banks and 12:1 for smaller

banks.• Example: If Fed buys $1B in Treasuries from JPMorgan, JPM could loan

out up to 24B to borrowers. Therefore, when the Fed increases the monetary base, it has a multiplier effect on the economy

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• There is a misunderstanding about the role Fed plays in the economy. The Fed is collateralized with high quality collateral (discuss recent corporate bond purchases) and is senior in the waterfall in all transactions. That means that the Fed is in the safest position regarding financing and loans of all parties involved. This massively limits their risk.

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Commercial:Central Banks – Federal Reserve:

For example, the recent programs that the Fed announced all had either equity investments by Treasury or loans provided by Treasury to the Fed to fund these programs. The Fed also created money to fund these programs, but Treasury is taking the first losses, not the Fed.

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– Pension Funds:• Pension Funds are buyers of Bonds because they need the returns

that bonds generate to meet their obligations to employees

• The size of Pension Funds dictates that they make long-term investments in products they don't have to exit

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– Pension Funds – Largest Pension Funds in the world:

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– Insurance Companies:• Insurance companies are buyers of Bonds because they seek to

generate investment returns in excess of their claims.

• They are large in size so they purchase products that they can hold without fear of exit

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– Insurance Companies –Largest insurance companies in the world

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Large Speculators: Large Speculators in Fixed Income are purchasing bonds with the intention

of selling prior to maturity. They may hold these securities for a few minutes to years but the intention is generally to exit prior to maturity

Mutual Funds / ETF’S

Hedge Funds

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Large Speculators – Largest Fixed Income ETF's

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Large Speculators: Mutual Funds/ETF’s

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Hedge Funds

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Market Makers:

Fixed Income Asset Class is dominated by Banks in Market Making

Banks benefit from:1. Large balance sheets2. Tight knit dealer community – they work to keep proprietary trading

firms out3. Complexity keeps products away from electronic algorithms

1.Created Structured Products and other special products (CDS) to give themselves new revenue centers.

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Market Makers:

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Market Makers:

Proprietary Trading Firms are dominant in the centrally cleared electronic side of fixed income trading

Largest Fixed Income Proprietary Trading Firms:1.DRW2.Jump Trading3.Citadel4.CTC

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Small Speculators/Retail Traders:

Retail investors in Fixed Income are in 2 categories:

– 1.) Traders – usually trade futures and fixed income ETF’s

– 2.) Small investors – invest in Fixed Income Mutual Funds, closed end funds, and municipal bonds

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How Big Money Trades Section 6d:

7 Edges of Big Money Traders within Fixed Income Markets

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7 Edges of Big Money Traders – Within Fixed Income Markets - Objectives

Go over how the seven edges are using by big money trader within fixed income markets.

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7 Edges of Big Money Traders

7 Edges of Big Money Traders

1. Expertise in a Market or Strategy2. Trade with Edge to Fair Value3. Trade with Positive Reversion4. Use Flows to Make Trading Decisions5. Identify Asymmetric Trade Setups6. Manage Risk through Spreads and Relative Value 7. Use Instrument Selection to choose the Optimum Strategy to maximize

their Trade Idea

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7 Edges of Big Money Traders – Within Fixed Income Markets

Edge 1) Expertise in a Market or Strategy

Because of the nuances of Fixed Income, there are professional traders who focus solely on a segment or strategy of Fixed Income

For example, there is a whole group of traders who trade Mean Reversion in the yield curve via US Treasuries. This group has been led by Ray Cahnman, who is probably the best trader ever in this space. Ray’s firm, Transmarket, trained many of the top curve traders over the years.

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Edge 1) Expertise in a Market or Strategy (Continued) At Banks, traders are assigned to desk to trade specific types of bonds such

as:– Corporates– Agencies (FHA, SBA, GNMA)– Sovereign Bonds (Europe, Asia)– Municipal Bonds– Structured Products (CDO)– Credit Default Swaps

Traders in these segments are experts in their respective segment.

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Edge 1) Expertise in a Market or Strategy (Continued) Macro – How understanding Fixed Income makes you a better trader!

– Best Macro Fund managers I have seen understand Fixed Income and understand the effect interest rates have on FX, Equities and commodity prices.

– In addition to having an edge in understanding Fixed Income, that understanding carries over to being an edge in trading other strategies.

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Edge 1) Expertise in a Market or Strategy (Continued) For example, many stock traders trade equities and focus on stocks and

Indexes. However, they often get caught on the turns because Bear and Bull Markets originate out of credit situations.

Credit is a huge issue both for valuations of interest paying securities for equities.

Companies are sensitive to interest rates and access to credit.

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Edge 1) Expertise in a Market or Strategy (Continued) When credit stress arises, credit access disappears. Weak or marginal companies are usually accompanied by high debt levels. Their continuance is based not only on their ability to overcome their debt

burdens but also based on economic cycle (tied to rates!) and access to continued credit.

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Edge 1) Expertise in a Market or Strategy (Continued) Toys R’ Us is a great example of what happens when a company loses

access to credit. They were unable to roll this bonds and when it looked like they would be

unable to do so, their bonds were immediately destroyed.

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7 Edges of Big Money Traders – Within Fixed Income MarketsEdge 1) Expertise in a Market or Strategy (Continued) Top Relationships to monitor to improve your trading:

– This is a list of fixed income relationships I monitor to be attuned to credit conditions– 2-10 Yield Curve Spread

• The shape of the yield curve is a MAJOR indicator for overall market health.• It's important to understand that this indicator can take time to bleed over into the equity

market.• In today’s day and age, if an indicator doesn’t work immediately, people dismiss it.• Yield Curve is one of those indicators that can effect things immediately or it may take time.• The core business of banks is to leverage deposits by borrowing short and lending long. If a bank

can borrow at 1% and lend at 4%, they are making a 3% spread and if they use leverage 10x leverage in doing so, they make 30% return on capital. As the spread is widens, they are more incentivized to loan money. Historically, when the economy would become overheated (higher inflation), the Fed would respond by raising short term rates which in theory would “flatten” the yield curve. As the curve flattened, banks would lose incentive to lend. Without banks lending, the economy would slow. In recent years, we have entered a different dynamic where the Fed has had the curve flatten by the long end rates moving lower as investors anticipated deflation.

• I think this indicator still has merit70

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Edge 1) Expertise in a Market or Strategy (Continued) Top Relationships to monitor to improve your trading (Continued):

– This is a list of fixed income relationships I monitor to be attuned to credit conditions– 2-10 Yield Curve Spread (Continued)

• The core business of banks is to leverage deposits by borrowing short and lending long.• If a bank can borrow at 1% and lend at 4%, they are making a 3% spread and if they use

leverage 10x leverage in doing so, they make 30% return on capital.• As the spread is widens, they are more incentivized to loan money.• Historically, when the economy would become overheated (higher inflation), the Fed would

respond by raising short term rates which in theory would “flatten” the yield curve.• As the curve flattened, banks would lose incentive to lend.• Without banks lending, the economy would slow.• In recent years, we have entered a different dynamic where the Fed has had the curve

flatten by the long end rates moving lower as investors anticipated deflation.• I think this indicator still has merit

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– US2Year Note – FedFunds Rate• The 2 year Note is a free floating Note that responds to market

supply/demand where the Fed Funds Rate is a fixed interest rate• Federal Funds Rate - target interest rate set by the Federal Open Market

Committee (FOMC) at which commercial banks borrow and lend their excess reserves to each other overnight.

• The reason I like this indicator is it shows whether Fed Policy is too tight or loose. For example, earlier in 2020, the 2 year note was trading significantly under the Fed Funds Rate creating a short term yield curve inversion. The last thing the Fed wants in an economic crisis is an inverted yield curve. There is a thought that the market can force the fed to make interest rate changes (especially cuts).

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– US2Year Note – FedFunds Rate

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– For charting, I like to chart actual yields and I have been using ETF’s because they are no roll issues and have continuous data streams unlike futures.• LQD-IEF Spread• HYG-LQD Spread• IEF Volatility

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– LQD-IEF Spread• LQD - The iShares iBoxx $ Investment Grade Corporate Bond ETF seeks to

track the investment results of an index composed of U.S. dollar-denominated, investment grade corporate bonds.

• IEF - The iShares 7-10 Year Treasury Bond ETF (IEF) seeks to track the investment results of an index composed of U.S. Treasury bonds with remaining maturities between seven and ten years.

• I track this spread because it is a measurement of risk appetite. When this spread is tight, it shows that investors are willing to take take on higher risk to gain more yield. They have less concern that the companies whose bonds are in LQD will default. When the spreads widens, it shows concern over the risk in corporate bonds and investors would rather hold treasuries

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– LQD-IEF Spread

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– HYG-LQD Spread• HYG - The iShares iBoxx $ High Yield Corporate Bond ETF seeks to

track the investment results of an index composed of U.S. dollar-denominated, high yield corporate bonds.

• This spread also measures risk appetite. High Yield and Junk Bonds (JNK ETF) are the highest interest rate paying bonds. When investors feel like economic prospects are strengthening or are strong, they are will seek the highest yields. When the economy is weakening, they will seek to exit higher risk bonds to limit default risk and will rotate to treasuries

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– HYG-LQD Spread

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– IEF Volatility• I like to watch the volatility in fixed income.• Implied volatility often leads major shocks as investors begin to hedge

their risks through option purchases.• When volatilities move to new lows, it is often a sign that investors

believe that risks have passed, and the environment is much safer (usually bullish or quiet) going forward.

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– IEF Volatility

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Edge 2) Trade with Edge to Fair Value

Fixed Income is largely a Relative Value trade. Traders create models based on the value of the underlying securities and then trade around that fair value by marking up their offers and marking down their bids.

Factors that affect the model value are:– Changes in interest rates– Changes in default risk– Prepayments

When there is a change in these inputs, there is a change in Fair Value and it will be reflected in Model Pricing and in the Bid/Offer in the market

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Edge 3) Trade with Positive Reversion

Again, because Fixed Income is so Relative Value based, traders work to enter and exit on positive reversion

Entry is especially based on positive reversion

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Edge 4) Use Flows to Make Trading Decisions

Classic example that can be used here is the old adage “Don’t Fight the Fed!” which was coined by Marty Zweig. If the Fed is engaging in active manipulation of rates via security purchases and interest rate reductions, the path of least resistance is to go with them

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Edge 5) Identify Asymmetric Trade Setups

Basis Trading – Because Futures contracts are physically settled (deliverable) and have defined specs of what qualifies as deliverable, a trading called Basis Trading emerges.

When you own a future you are entitled to what is called the Cheapest to Deliver Bond

Cheapest To Deliver (CTD) - The term cheapest to deliver (CTD) refers to the cheapest security that can be delivered in a futures contract to a long position to satisfy the contract specifications. Specifically, it is the bond that maximizes the return to the arbitrageur engaging in buying the basis (buying cash bond + selling future)

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Edge 5) Identify Asymmetric Trade Setups (Continued)

It is relevant only for contracts that allow a variety of slightly different securities to be delivered.

This is common in Treasury bond futures contracts, which typically specify that any treasury bond can be delivered so long as it is within a certain maturity range and has a certain coupon rate.

The coupon rate is the rate of interest a bond issuer pays for the entire term of the security.

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Basis trading has 2 imputed options based around the requirement that you are required to deliver the cheapest to deliver bond. They are:1. Time to Deliver Option2. Quality Option

If the CTD changes, you get the benefit of owning a higher paying bond when you had modeled for a lower paying bond.

This behavior works in your favor when you are required to deliver (short the future).

You can read further about Basis trading in the Appendix of Resources

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Great fixed income traders are typically patient and wait for situations (like last winter with COVID-19) to put on large positions when the mispricingsare larger.

This creates trades with combination of high win rate and high R/R.

As we will see in Edge 7, using different instruments also allows the to identify the best R/R setup and purse that combination.

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Edge 6) Manage Risk through Spreads and Relative Value

Fixed Income trading is probably the asset class with the highest amount of relative value trading.

The yield curve trade is all about relative value on the interest rate curve. Traders trading RV utilize strategies such as spreads, butterflies and

condors to “isolate” the edge via RV models. They then wait for the model to revert to take the position off.

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Edge 6) Manage Risk through Spreads and Relative Value (continued)

For example, a ratio can be tracked on the FYT (5-yr Notes/10-yr Notes) Spread.

The ratio is tracked, and statistical extremes are identified around the mean.

Traders then typically stack bids below and offers above fair value. Their objective is to sell at a statistical extreme to fair value and then exit

on reversion to the Mean. Everything we learned in Sessions 1 and 2 on Mean Reversion behavior

applies to this trade idea.

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Edge 6) Manage Risk through Spreads and Relative Value (continued)Building a Spread

– The spread begins with what we already know about U.S. Treasury futures, they trade like their cheapest-to-deliver (CTD) securities and we can calculate their implied BPV.

– If we wanted to buy a 2/10 yield spread using futures, we must first identify which U.S. Treasury futures contracts we want to use to build the spread. We know there is a 2-year futures contract but what about the 10-year side?

– There are two futures contracts listed by CME Group that derive their value from 10-year U.S. Treasury securities, the Classic 10-Year and the Ultra 10-Year. Which should we use? The Ultra-Ten Year tracks a CTD that trades closer in maturity to the OTR 10-year so we will use it for our example. So for our example we would buy the 2-year future and sell the appropriate number of Ultra 10-Year futures.

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Edge 6) Manage Risk through Spreads and Relative Value (continued)Building a Spread (Continued)

– The second step is to identify each contract’s CTD issue, then, based on its CTD’s BPV and conversion factor, calculate each contract’s implied BPV. Then we can compare the respective BPVs and, with a little math, arrive at the appropriate spread ratio (SR). Mathematically it would look like this:• Spread Ratio (SR) = BPVultra-ten ÷BPV2-year• Assume that the 2-Year (TUH7) has a BPV of $46.25 per contract and

the Ultra 10-Year (TNH7) has a BPV of $128.78. Plug this into the formula above and we get:

• SR= 128.78 ÷ 46.25 = 2.78, or roughly 3:1 TUH7 to TNH792

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– By buying three TUH7 contracts versus one TNH7, this spread is effectively dollar-neutral.

– That means it is less subject to profit and loss based on direction of the market and more subject to change in the yield difference between the contracts.

– This trade is about changes in slope rather than changes in outright yield.

– Because U.S. Treasury futures prices move in an inverse relationship to yield, if one is buying the 2/10 they are anticipating the slope to steepen, or increase, between 2/10s.

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– We recognize traders and risk managers utilize U.S. Treasury futures to trade the slope of the yield curve and conveniently list yield curve trades weighted and rounded to whole number ratios on the CME website and on CME Globex.

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Edge 6) Manage Risk through Spreads and Relative Value (continued)

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Edge 7) Use Instrument Selection to choose the Optimum Strategy to maximize their Trade Idea

Similar to other asset classes, we want to look at a matrix of possibilities for expressing a trading idea.

Example: Let’s say we think long term rates are going rise due to an inevitable round 2 of large fiscal stimulus. We think this large round of stimulus will cause supply (from larger bond offerings needed to finance larger deficits via the Stimulus plan) to swamp demand.

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7 Edges of Big Money Traders – Within Fixed Income MarketsEdge 7) Use Instrument Selection to choose the Optimum Strategy to maximize their Trade Idea

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Edge 7) Use Instrument Selection to choose the Optimum Strategy to maximize their Trade Idea (Continued)

Example: (continued)– We could:

• - Ten Year Future• -1 10 Year Note/+10 2 Year Notes (ratioed)

– This spread benefits from the curve steepening while neutralizing overall rate risk

• -1 IEF/+10 SHY• + 10 Year Note Puts• + IEF Puts• +IEF Puts/+10 SHY Calls• +IEF Puts/-10 SHY Puts Spreads

– All 7 of these options benefit from long-term rates rising (provided short term rates don’t rise more!)

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Edge 7) Use Instrument Selection to choose the Optimum Strategy to maximize their Trade Idea (Continued)

Example: (continued)

The optimal trade is to +TY G21 137.5 Puts

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Trading Idea Rates will move higher on increased supply of Treasuries being sold to fund Stimulus #2

Possibilities: R/R-10 Year Future -138'07 3.11+10 TY G21 137.5 Puts 48/64 7.33-IEF -120.19 1.6+10TUH1/-1TYH1 965 5/16 2.4+10SHY/-1 IEF 743.32 1.98+IEF Puts Disqualified on spreads too wide

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Appendix of Resources:

http://www.yieldcurve.com/Mktresearch/files/FuturesBondBasis_Part1.pdf http://www.yieldcurve.com/Mktresearch/files/FuturesBondBasis_Part2.pdf https://www.cmegroup.com/education/files/yield-curve-spread-trades.pdf https://www.cmegroup.com/education/courses/understanding-futures-spreads/trading-the-treasury-

yield-curve.html https://www.sec.gov/spotlight/fixed-income-advisory-committee/survey-of-microstructure-of-fixed-

income-market.pdf https://www.sifma.org/wp-content/uploads/2019/10/SIFMA-Insights-Electronic-Trading-Market-

Structure-Primer.pdf https://www.mercatus.org/system/files/sumner_-_policy_brief_-

_understanding_the_federal_reserve_-_v2.pdf

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http://www.yieldcurve.com/Mktresearch/files/FuturesBondBasis_Part1.pdfhttp://www.yieldcurve.com/Mktresearch/files/FuturesBondBasis_Part2.pdfhttps://www.cmegroup.com/education/files/yield-curve-spread-trades.pdfhttps://www.cmegroup.com/education/courses/understanding-futures-spreads/trading-the-treasury-yield-curve.htmlhttps://www.sec.gov/spotlight/fixed-income-advisory-committee/survey-of-microstructure-of-fixed-income-market.pdfhttps://www.sifma.org/wp-content/uploads/2019/10/SIFMA-Insights-Electronic-Trading-Market-Structure-Primer.pdfhttps://www.mercatus.org/system/files/sumner_-_policy_brief_-_understanding_the_federal_reserve_-_v2.pdf


Questions & Homework

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Homework from Today:

For the next call:

– List 3 concepts that you learned from the webinars:

– What's one idea from the 7 Edges of Big Money Traders that you could incorporate into your trading? How would you expect it to improve your performance?

– What beliefs do you hold that should be reevaluated as a result of what you learned today?

– What are new beliefs you have learnt from this call today?

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Q & A with Bryan Hou

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Guest – Bryan Hou

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Portfolio Manager, Quant Strategy & Risk Premia, CPPIB

Mr. Hou has been with Canada Pension Plan Investment Board for almost 6 years and has been in the Quant Strategy & Risk Premia group for over 3 years.

Mr. Hou leads the macro strategy portfolio engineering group that implement quantitative factors, portfolio construction methods to harvest alpha and assists in research and day to day portfolio management and trading.

Prior to joining CPPIB, Mr. Hou worked in quant equity department in Royal Bank of Canada Global Asset Management, a wealth manager for both institutional and retail investors. Mr. Hou graduated from the University of British Columba with a master degree in Software system and earned the CFA designation since 2016.Cop

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How Big Money Trades Session 6 – Fixed Income:��DisclaimerDisclaimer (Continued)Disclaimer (Continued)Disclaimer (Continued)Today’s Objectives:How Big Money Trades Section Review of Systems Thinking�Systems Involved in Making a Trade and Determining its OutcomeSystems Involved in Making a Trade and Determining its OutcomeSystems Involved in Making a Trade and Determining its OutcomeSystems Involved in Making a Trade and Determining its OutcomeSystems Involved in Making a Trade and Determining its OutcomeSystems Involved in Making a Trade and Determining its OutcomeSystems Involved in Making a Trade and Determining its OutcomeSystems Involved in Making a Trade and Determining its OutcomeSystems Involved in Making a Trade and Determining its OutcomeHow Big Money Trades Section Session 6:��Introduce Fixed Income Market Structure ��Introduce Fixed Income Market Structure - ObjectiveIntroduce Fixed Income Market Structure and ThoughtsIntroduce Fixed Income Market Structure and ThoughtsIntroduce Fixed Income Market Structure and ThoughtsIntroduce Fixed Income Market Structure and ThoughtsIntroduce Fixed Income Market Structure and ThoughtsIntroduce Fixed Income Market Structure and ThoughtsIntroduce Fixed Income Market Structure and ThoughtsIntroduce Fixed Income Market Structure and ThoughtsIntroduce Fixed Income Market Structure and ThoughtsIntroduce Fixed Income Market Structure and ThoughtsIntroduce Fixed Income Market Structure and ThoughtsIntroduce Fixed Income Market Structure and ThoughtsIntroduce Fixed Income Market Structure and ThoughtsIntroduce Fixed Income Market Structure and ThoughtsIntroduce Fixed Income Market Structure and ThoughtsHow Big Money Trades Session 6:��Roles and Strategies of 4 Market Participants within Fixed Income Markets��Roles and Strategies of 4 Market Participants within Fixed Income Markets - ObjectivesRoles and Strategies of 4 Market Participants within Fixed Income MarketsRoles and Strategies of 4 Market Participants within Fixed Income MarketsRoles and Strategies of 4 Market Participants within Fixed Income MarketsRoles and Strategies of 4 Market Participants within Fixed Income MarketsRoles and Strategies of 4 Market Participants within Fixed Income MarketsRoles and Strategies of 4 Market Participants within Fixed Income MarketsRoles and Strategies of 4 Market Participants within Fixed Income MarketsRoles and Strategies of 4 Market Participants within Fixed Income MarketsRoles and Strategies of 4 Market Participants within Fixed Income MarketsRoles and Strategies of 4 Market Participants within Fixed Income MarketsRoles and Strategies of 4 Market Participants within Fixed Income MarketsRoles and Strategies of 4 Market Participants within Fixed Income MarketsRoles and Strategies of 4 Market Participants within Fixed Income MarketsRoles and Strategies of 4 Market Participants within Fixed Income MarketsRoles and Strategies of 4 Market Participants within Fixed Income MarketsRoles and Strategies of 4 Market Participants within Fixed Income MarketsRoles and Strategies of 4 Market Participants within Fixed Income MarketsRoles and Strategies of 4 Market Participants within Fixed Income MarketsRoles and Strategies of 4 Market Participants within Fixed Income MarketsRoles and Strategies of 4 Market Participants within Fixed Income MarketsRoles and Strategies of 4 Market Participants within Fixed Income MarketsRoles and Strategies of 4 Market Participants within Fixed Income MarketsRoles and Strategies of 4 Market Participants within Fixed Income MarketsRoles and Strategies of 4 Market Participants within Fixed Income MarketsRoles and Strategies of 4 Market Participants within Fixed Income MarketsHow Big Money Trades Section 6d:��7 Edges of Big Money Traders within Fixed Income Markets��7 Edges of Big Money Traders – Within Fixed Income Markets - Objectives7 Edges of Big Money Traders7 Edges of Big Money Traders – Within Fixed Income Markets7 Edges of Big Money Traders – Within Fixed Income Markets7 Edges of Big Money Traders – Within Fixed Income Markets7 Edges of Big Money Traders – Within Fixed Income Markets7 Edges of Big Money Traders – Within Fixed Income Markets7 Edges of Big Money Traders – Within Fixed Income Markets7 Edges of Big Money Traders – Within Fixed Income Markets7 Edges of Big Money Traders – Within Fixed Income Markets7 Edges of Big Money Traders – Within Fixed Income Markets7 Edges of Big Money Traders – Within Fixed Income Markets7 Edges of Big Money Traders – Within Fixed Income Markets7 Edges of Big Money Traders – Within Fixed Income Markets7 Edges of Big Money Traders – Within Fixed Income Markets7 Edges of Big Money Traders – Within Fixed Income Markets7 Edges of Big Money Traders – Within Fixed Income Markets7 Edges of Big Money Traders – Within Fixed Income Markets7 Edges of Big Money Traders – Within Fixed Income Markets7 Edges of Big Money Traders – Within Fixed Income Markets7 Edges of Big Money Traders – Within Fixed Income Markets7 Edges of Big Money Traders – Within Fixed Income Markets7 Edges of Big Money Traders – Within Fixed Income Markets7 Edges of Big Money Traders – Within Fixed Income Markets7 Edges of Big Money Traders – Within Fixed Income Markets7 Edges of Big Money Traders – Within Fixed Income Markets7 Edges of Big Money Traders – Within Fixed Income Markets7 Edges of Big Money Traders – Within Fixed Income Markets7 Edges of Big Money Traders – Within Fixed Income Markets7 Edges of Big Money Traders – Within Fixed Income Markets7 Edges of Big Money Traders – Within Fixed Income Markets7 Edges of Big Money Traders – Within Fixed Income Markets7 Edges of Big Money Traders – Within Fixed Income Markets7 Edges of Big Money Traders – Within Fixed Income Markets7 Edges of Big Money Traders – Within Fixed Income Markets7 Edges of Big Money Traders – Within Fixed Income Markets7 Edges of Big Money Traders – Within Fixed Income Markets7 Edges of Big Money Traders – Within Fixed Income Markets7 Edges of Big Money Traders – Within Fixed Income Markets7 Edges of Big Money Traders – Within Fixed Income Markets7 Edges of Big Money Traders – Within Fixed Income MarketsAppendix of Resources:How Big Money Trades �Session 6:��Questions & Homework�Homework from Today:QuestionsHow Big Money Trades Session 6:��Q & A with Bryan HouGuest – Bryan HouSlide Number 109Questions

how big money trades session 6 – fixed income...u.s. government required disclaimer – commodity...

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