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Closing the Gap - Futures Edition

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TUT Spread

Closing the Gap - Futures Edition

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Tony: Thomas, we're back, my friend, Closing the Gap, Futures Edition.
Tom: Pete, how are you.
Pete: I'm great. How are you guys?
Tom: We are so excited to be expanding this show to weekly. Good job out of you.
Pete: We are, too. Thanks, again. I love it.
Tony: You know what? If Friday couldn't get any better, it just did.
Pete: Fantastic.
Tom: I am being nice. Anyway, it's going to be great. I can't wait to do this weekly. It's one of our most popular shows. I think it's the only show where we do something that we've never done before. We learn a lot of stuff, but there's nothing like ... I can't think of any trade we've never made before outside of these ... I'm not going to call them exotic, but they are a little bit different ways to look at futures than we've looked at in the past. Again, when you do different types of futures spreads you are extending duration, and when you extend duration you reduce risk. That's the nature of different types of futures spreads.
Pete: Right. I am so excited to be here. It's the best part to end my week. We have felt that this has been such a powerful platform for us to talk about our products. You guys have been such great partners.
Tom: The funny thing is the more you get to talk about things like this in this kind of a setting, you can see how much better everybody gets at articulating the space. In just six months, nine months ... you're a very different speaker today than you were nine months ago.
Pete: You guys were incredibly patient back then. You were.
Tom: It's a really positive thing, because then you see, OK, this is how we get the message across. Then all of a sudden more people tune in. I've always been very anti-exchange education, because it never changes. It never evolves. You're doing something that's extraordinary, and this is one of the things that ... To be honest, I didn't know if the CME was capable of this, but you've brought it to the table, which is essentially ... You are part of what I call evolving investor education, which nobody in the options side or stock side has ever done before. It's stagnant. It's the same stuff from 20, 30, years ago. We're doing stuff now with investor education that's never been done before.
Pete: Right, and we're so excited to be part of that, too. We feel, too, some of the tools we've built we'll talk in future segments about, like the Futures Institute and things like that, are really important parts of bringing that type of education and getting away from volume and open interest levels to really getting into a discussion about how people can empower themselves using futures and options on futures.
Tom: By the way, if you'd like to meet Pete in person, the next live show we're doing together will be in Portland, Oregon.
Tony: Very good. I've been fighting with him all week.
Tom: It's not Or-gone.
Tony: It's not going anywhere.
Tom: In two weeks, it is on March 14, on Saturday. I think you'll be leading off the day or talking early.
Tony: Right.
Tony: Will you have 8x10 glossies that you will be signing?
Pete: Of you? Yes, I actually a whole series of you that I will be.
Tony: Cute.
Tom: After Pete gets done speaking he will be hanging around for most of the day. So people can get a chance to talk to you and ask questions. I'm telling you, it's a great resource. If you come out to the show in Portland, and you want to corner Pete and get a chance to pick his brain on anything, nothing's off limits, please do. Not this one guys, it's a different one. It's March 14th. It's a Saturday. Come on out and pick his brain.
Pete: [crosstalk 00:03:42]
Tony: Always generous with your time. It's very cool.
Tom: So let's do it. Today, what are we covering?
Pete: Today we're covering what we call the TUT spread.
Tom: TUT spread.
Pete: We've talked about it ...
Tom: Like King Tut.
Pete: Yeah, like King Tut. TUT stands for tens under twos, or twos-tens, spread. A couple of months ago we looked at the NOB spread, Notes of Bods, a longer term date of maturity, so 15 and ...
Tom: Tut is tens under twos. Does that mean whatever we do on the ten year is what we're doing on the spread?
Pete: No. I almost spun it around the other way because I knew you'd be upset with me for saying it.
Tom: So it's twos over tens.
Pete: It's twos over tens.
Tom: Thank you very, much.
Pete: We can just call it twos over tens. We can just call it twos over tens.
Tony: It's two before ten except when [crosstalk 00:04:29].
Tom: It's a lot easier. For once, in the futures, I like to keep something consistent, so twos over tens.
Pete: Right, and remember, whatever yield curve strategy we look at, we're always going to look at whatever the shorter duration leg is. Whatever the shorter maturity leg is, that's going to be what we're doing in the spread.
Tom: Whatever we do in the spread, we do on the first one that we're talking about.
Pete: Right, so if we're buying the spread, we're buying the twos. We're selling the tens. If we're selling the spread, we're selling the twos, buying the tens.
Tom: Does this particular spread trade as a spread?
Pete: This particular one does trade as a spread. It trades as a spread, but you can also leg it individually. We set it up to leg it individually.
Tom: What would the symbols be?
Pete: /ZT is the symbol for the two-year. /ZN is the symbold for the ten-year.
Tom: What would the spread symbol be if there ... I don't even know the spread symbol. Do you know what it is?
Pete: I don't off-hand. Here's the thing. The spreads are wonderful things to trade, but they're quoted in chains for the day. They're not quoted as a spread. They're quoted as plus one or minus one, or plus three, minus three, for the day.
Tom: Is that ticks?
Pete: That's ticks. It's the chains from the previous day is the way they're quoted. They're not quoted as a spread. This is why ... They're out there. They're very interesting vehicles to use, but there's a different quoting convention, and I didn't think we necessarily needed to go ...
Tom: Do you believe in a futures god? Because if there's a futures god up there and you're listening ...
Tony: He's playing a mean trick.
Tom: Just make this stuff simple for all of us and I promise your volume will go up by 50%.
Pete: We're working on that everyday. There is a lot of thought about how do we create a unified, simplified experience for getting into all these products.
Tom: The spread between the yields on the ten-year notes and the two-year notes is an important gauge regarding the current shape of the yield curve. The yield curve simply plots the yields on bonds with varying maturities, typically three months to 30 years. Let's talk about the yield curve for just a second. The yield curve plots the maturities, but what would the average self-directed investor like myself, and like Tony, what would we be ... What can we take away from the yield curve? What does it mean to us?
Pete: It's a great question. A yield curve is basically telling you what the cost of money is out across the maturities spectrum. Usually, and what we've seen, is that shorted dated maturities, to borrow money, there's less risk going out in terms of time. They usually command a lower interest rate. That slope, that traditional upward slope ... The further out I go, the more that there are variables, whether it be inflation or other dynamics.
Tom: Sensitivity to risk.
Pete: That curve basically shows where the market is willing to borrow and lend money depending on the time period. The shape of that, and as that changes, that gives us a good indication of supply and demand for money across the curve. Within that we can get a sense of if people are making long-term investments. There will be greater demand for money further out for capital investments. Is there a flight to quality? That will usually dictate and show itself through, sometimes, the shorter end of the curve railing more than the longer end. There's lots of ways that we could start to incorporate, not only the idea of a yield curve trade but watching the dynamics of the yield curve. Now, this twos-tens that we're looking at is very interesting because it's one that central banks follow very closely. They feel it's an indicator of financial health or financial stress within the system. Paradoxically, when we see the twos-tens curve revert, or come in, like we're seeing here ... again, that is the ten-year ...
Tom: When you say it's coming, you just mean because it's at the low end of its range.
Pete: It's at the low end of its range, yes. The difference between these two ... In other words, the yield curve is flattening. The ten-years are getting cheaper in relationship to the two-years. The one thing I want to say here is, we're all talking about this in terms of yield.
Remember, when we talk in terms of yield then we talk in terms of price of the instruments. They're the reciprocal of one another. They're the revers. In other words, when yields are rising, the futures products, bonds and notes, will be falling. When yields are falling, bond prices rally.
Tom: On this little graph that you have up here, are you showing price or yield?
Pete: This is yield right here.
Tom: Oh, yield.
Pete: This is yield.
Tom: Got it.
Pete: Basically, what this is showing is that ...
Tony: We don't usually graph yield.
Pete: The relationship ... when we start to graph the spread, unless we weight them, it doesn't show us clearly a picture.
Tom: If we flip-flop this into the inverse and we looked at price, it would be at the top end of the range.
Pete: It certainly would be.
Tom: The spread between the two can be seen by plotting the ten-year yield minus the two-year yield. The TUT spread of 135 represents 135 basis points ... that means prices are high, yields are low ... a level that is historically low. Traders keep an eye on the TUT spread as a signal of where interest rates may be headed. How does that ... I'm still confused as to how that signals future interest rate risk. Here's that same graph.
Pete: This is that graph blown up. It's the idea of as this yield curve compresses, it can compress for a number of reasons. Part of the reason why we've seen this yield curve compress is that the long end has not fallen off as dramatically, or yields risen as dramatically, because we haven't seen any inflation. All of a sudden, now we're getting more definite signals from the Fed that they could increase the rate cycle earlier.
Tom: What I'm saying is that if I look at this, the first thing I want to do is ... Again, remember, I look at this and I see the opposite price-wise. The first thing that I want to do price-wise to fade this is sell ten-year and buy two-year. What you're saying is this spread is kind of an indication that lower rates are here to stay, or here for the short term, whatever.
Pete: I think what it's saying is that the market believes that. The one thing we know is ... and we've talked about this the first thing. Nobody knows where the market is going. I think that it's a very interesting dynamic to see that the last time we traded down like this the market held these levels very well and we saw the yield curve expand out.
What that mean is that ... The Fed also looks at this in terms of its policy making. If they are inclined to see this compress too much, will they be less likely to move? Can we see reversion to more the middle of the range on this [inaudible 00:11:23].
Tom: Because the two-year doesn't move at all, or moves really little in graphical terms, you paint this as the spread is really the more interesting trade.
Pete: The spread is the more interesting trade. When we go on to the next one, we'll see percentage change. This is great. I've got to shout out to the research team, Mike [inaudible 00:11:45] in particular. I tend to get these in as close as possible, because I want them to be current. They are unbelievable with what they can do in terms of creating great content.
This shows that two-year yield. The percentage change of it is rather dramatic. In terms of volatility ... and in terms of volatility of this spread, it's very interesting. It's gone from 9% to almost 48% volatility. This is at a point right now where ... It's an inflection point.
Either we will see that this will flatten ... this is at a historic near term low. Either we will see a it flatten and we'll actually see the short end still gain ground on the long end if they are more aggressive in their rate hiking, or we will see that this is a possible reversion plan.
Tom: Pete, the ten-year is one of your most popular products.
Pete: It is.
Tom: Is the two-year ... Give us an idea of how the two-year trades. Does it trade similar to the thirty-year? Where does it fall in the popularity game?
Pete: It's a great question. The benchmarks are the ten and ... what you and I call the thirties. It's now called the classic bond, because it's a 15 to 25-year deliverable. We have an ultra-bond, which is 30-plus years. The twos and the fives trade over 100,000 contracts. The fives trade close to 250,000 contracts a day. They trade in quarter point increments, where the notes trade in half point increments, and the bonds trade in full point.
Tom: What does the two-year trade in?
Pete: The two-year trades at quarter point increments.
Tom: The two-year and the five-year trade in quarter point?
Pete: Two and five trade in quarter point increments. The main difference ... We'll see this when we go into the weighting of the spread relationship. The two year contract calls for $200,000 notional delivery. All the other contracts call for $100,000 notional delivery.
Tony: Since you're talking about delivery ... I don't know if you know the numbers off the top of your heat, but you had walked in here earlier and said that the classic bond has, which is rolling now and you're at the end of its roll. I didn't realize, or I never really looked at ... It wasn't really a relevant number to me, but it's interesting to know. You said that less than 10% actually goes to delivery, almost like being exercised in an option in the option world. You're saying around 10% or less?
Pete: Actually, 7% or less.
Tony: Is it the same in the notes? I would expect it to be a little bit more in the two-year. That would just be my guess.
Pete: I think it's pretty much consistent throughout the curve. The two-years are more institutionally dominated, on the options side especially. We are doing a great job streaming prices in there, but you're not going to see the volume numbers that you see in the ten or the classic bonds.
Tom: How much is a tick? $7.00, is that what you're talking about, per tick?
Pete: Right.
Tom: So it's going to be $7.00 and ...
Pete: It's going to be 15.62. The contract's half ...
Tom: Half of 15.62.
Pete: No it's going to be 15.62, because the contract for the two-year is twice the size of all the others.
Tom: Oh, because the contract is twice ... Got it.
Pete: A quarter of a point ...
Tom: Got it. It's a $200,000 contract.
Pete: It's a $200,000 contract, right.
Tom: It's the same as the ten-year. It's just ... I got it, understood. Is the spread one-to-one?
Pete: When we weight our spreads ... we looked at the NOB spread. One of the important things we looked at was this idea of maturity and duration and the dollar value of a basis point move. The dollar value of a basis point move on these two, and we'll see it as we jump ahead ...
Tom: Perfect. It totally makes sense now. The shape of the yield curve gives investors a sense of economic expectations. In general, strong economies, steepening of the yield curve. Longer maturities increase more than shorter. That would be what we call normal, right?
Pete: Right.
Tom: Weaker economies, flattening of the yield curve, longer maturity yields decrease more than shorter maturity yields. That's what we've seen over the last, probably, six, seven years.
Pete: Right. That is, as you said, that's a very traditional way to look at it. We're seeing a little bit different dynamic play out right now.
Tom: Possible curve trades are flattener or steepener strategies consisting of getting long or short near-term front and long-term back bonds. If this seems confusing, it is for everybody. I've got to tell you, remember, we're agnostic to product here. We're agnostic to product, but we're not agnostic ... I'm sorry. We're agnostic to product, but we're open to opportunity. One of the reasons why this is so important is because these are positions that trade like water.
Pete: Right.
Tom: For the small investor. For the independent retail investor like we are these are positions that trade just like water. Your ability to fill one, twos, fives, tens, whatever it is, you're not giving up more than a tick for the whole thing.
What's exciting about this, again, is if we look at extremes as opportunity, there's no probabilities associated with this. We're going to get to that later, because there's a whole different series of [inaudible 00:16:49] and things like that. What this is is just another product with a lot more opportunity and liquidity.
Pete: It's certainly ... It gives you a whole new set of tools to express opinions and find opportunities along the interest rate product curve.
Tom: The risk measure used for curve trades is the dollar value of a basis point, DV01, basically the delta of a bond. The back leg will always have a greater delta than the front leg so a hedge ratio must be calculated to result in a delta-neutral position. This is essentially the same as creating a delta-neutral position with options.
Everybody's familiar with delta-neutral with options. A little bit trickier, delta-neutral with futures. We always called this ... the word in the option world for this was a basis trade, not to confuse with terms we've used before, pairs trade, basis trade. This is no different than trading the spread, which is the relationship between the two instead of the two individual pieces.
Pete: That's what we're trying to do, and to express, again, expressing opinion that gives us a little bit more duration, a bit more time to be right and take out some of the noise that we see during the day.
Tom: Like any other pairs trade. It's to extend duration. The reason you extend duration is to give yourself time to be right. It's actually a math formula, except it doesn't have the [inaudible 00:18:14] piece to it. It just has the reduction of risk based on size.
Here you have this $200,000 notional product that moves a little slower than the $100,000 notional product. You're trading the spread between these two products. What you're hoping for is, whichever way you're betting, that the math equation around the way that products move gives you an opportunity to be right on either side of the trade. Again, having the ability to hold that spread there, that's the challenge. Calculating the spread ratio for the two-ten-year steepener ...
Pete: Right, the steepener, which means that we expect the value of the tens over the twos to move out. Remember, where we notionally weight at trade off times, when we look at a commodities trade, we're going to use this DV01, this dollar value of a basis point to weigh it at.
It's a relatively long equation, but the math is done for you very simply. If you go to CME and look under duration tool, it updates it in real time. Whether you're trading a twos, a fives, tens, the classic or the ultra bond, you can get that. The DV01 for the two-year is 37.94. For the ten-year note, it's 79.64. It's roughly a one-half of the other. The spread ratio is ...
Tom: It's a perfect ...
Pete: It's a perfect one-to-one, because ... and we highlighted this ... is that that two-year note is double the contract size. To figure out this ratio, we take the DV01, times it by the contract size, divide one by the other, we get to a very, very close one-to-one. That's the way we're going to express our opinion on this.
Tom: This is awesome. Let's take a look here ... now, what are we looking at here?
Pete: This is a chart of the volatility. I believe this is 90-day volatility of that spread relationship.
Tom: You have high volatility and you have high price. It just gets more interesting. Let's take a look. The trade example of the two-ten steepener, traders can take advantage of the current flat yield curve using futures. Remember, the spread ration is one two-year to one ten-year. If you did this one, you'd be selling the ten-year, buying the two-year. This is what I want to do.
Pete: If you like those aspects of ... We've seen its high side on prices. We've seen its high side on volatility. Remember there are options on futures on both of these. Adding, with the high volatility, adding a time decay component to it, could be a great opportunity here. It just was how much time and how much could we cover here?
Tom: The buying power effect, which is $2,200 ... I just put it up on my own screen. I tested it myself. I didn't write out the order yet, but it is $2,200. As pairs trades go, it's probably the least expensive at full margin. That $2,200 is your overnight requirement.
At $2,200 as an overnight requirement, being able to trade two futures, is probably ... is representative of your risk, too. It's on the low end of the overnight requirements. The spread, as an entry, probably doesn't move that much, but it's a great introduction into learning pairs trades and trading bonds.
Pete: Honestly, this, while presenting an interesting opportunity the NOB spread can be a little bit more of a wild ride for someone first trading that spread. This is kind of a nice way to get into it, and actually more relative to what's going on within the curve right now.
Tom: I set it up in Toss. Just so you know, you can set up the spread on the trade page. Both are supported. You can set it up as blast all, because I'm not going to ... Blast all just means that I'm going to simultaneously route two orders to the CME. I'm not going to pick pennies for bids and offers right now just for the sake of the show.
Pete: And you've got the [inaudible 00:22:10].
Tom: Yes. I filled both of them, basically, in one quick second. Let's see what happens. That was ...
Tony: 12723 and 4452. I'm sorry, no, no ...
Tom: Whatever, I just wanted to show that it's a single click. You don't have to think that you're this giant leg or doing this kind of stuff. It's just a single click, and then you have the position on it, and we'll see how we do. All right, let's keep going. We're going to run out of time here. I think ... because you guys, you put a lot into this stuff.
Pete: I know. This was such an interesting relationship. Really, I should save it for the next ...
Tom: I love the discussion of yield curving gold. What I want to do is I want to mix up some of these. I think everybody else loves this, too. While you were talking gold just rallied $6.00, $7.00 while you were talking. I love these discussions. Can we save this piece?
Pete: Sure.
Tom: We're over our time already. The markets are going to open in a second. I want to give this justice, because this is a really cool piece. This is how you add the [inaudible 00:23:26] portion.
Pete: Yes, it is.
Tom: Let's hold that thought. What I've done is I've just done the TUT spread for the first time, which is two over ... I'm sorry.
Pete: One-to-one on a relationship.
Tom: One-to-one on the relationship. Its two under ten, and I sold ... I'm sorry.
Pete: You sold the tens.
Tom: So I was actually long the spread.
Pete: You sold the tens. You bought the twos. You were long the spread, in spread convention terms. We're looking for that spread to widen out on a performance basis.
Tom: The ten-years are up, like, four ticks today. The ZTs are up seven, it looks like, so very interesting. Anyway, I learned something new today. That's all I care about. It's hard to teach the old dogs new tricks type thing. I learned something new. I'm extremely excited about it. I did it really small. I'm just going to see what happens.
We've had a lot of success with a lot of your trades. We've been getting out of them quick. I just want to show everybody it's simple to do, one click on the software, at least you understand it. I'm doing it from the short side of the ten-year and the long side of the two-year because I'm a bear on bonds.
Pete: That's one of the great things with this yield curve trade. You can express an opinion within the curve and add a little ... take out some of the noise.
Tom: It's just a new element.
Pete: It is. It absolutely is.
Tom: It's a new element with extend duration and use less capital. It's a less expensive, less risky trade than the NOB spread. That's all.
Pete: It is.
Tom: Pete, that was awesome. That was part one of the TUT Spread, the Futures Elements. Next week we will do part two, which is the TUT Spread and Gold.

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