US Treasuries vs Stocks - One Of These Things Does Not Look Like The Other...

    Today saw a massive short covering trade occur in the US Treasury market.  A broad base of traders got short treasuries over the past few days (long end auction setup trades...and the usual group who just MUST fade every move).  Yesterdays weak ADP and ISM data brought in a large buyer of bonds (and a medium size seller of stocks).  Today the stocks market went sideways while the Treasury market was rocked...the herd of Treasury shorts was caught and fear overtook all rational thought.  There was a very high volume short covering event in the morning that lasted for about an hour and saw 100mm/basis point trade in a straight line "up"  (this is 4x normal volume for that time period).  While all this craziness was taking place in the Treasury market...the stock market was "unch."  Its as though stock market participants were completely unaware of what was happening in the Treasury market. 

    3 weeks ago (March 14th), S&P futures opened 1554 while 10yr Treasuty futures opened @ 130-10.  Today, S&P futures closed @ 1555 "unch from 3 weeks ago" while 10yr treasury futures closed @ 132-26  (thats 2 1/2 POINTS on a 7yr piece of paper).  

 3 weeks ago the relationship between stocks and bonds was priced at fair value.  Today, the stock market hasn't moved and the Treasury market has been ROCKED.  On a relative value basis, the Treasury market is now 20 basis points rich compared to the stock market.  To put that in S&P terms...the S&P is currently trading 1555....if the S&P were to move to accommodate the move in the Treasury market...the S&P would need to trade 1450...that's 100 POINTS lower (or 6.4%).  This is the most rich these markets have been relative to each other in years.  The current correlation regime has lasted 9 months  (treasuries and stocks have been dancing with each other in a stable fashion for the past 9 months).  Even adjusting for regime change, this move today is the richest these markets have been even during this current 9 month regime.

    So, either the regime between bonds and stocks has just changed...or the market has just given traders with cash on the sidelines a gift.  History has taught us that regime changes don't happen very often...and the smart move for a trader has been to fade these attempts to "break the regime."  Its true that someday the regime will shift, and we will enter a new regime, and fading a move like this will lose money.  Do you think that just happened?  Do you really think we just entered a new regime?  Its true that Japan just embarked on a new round of QE...and it is a 2.5 times the size of current US QE, and North Korea is threatening war.   Should that break the regime of the relationship between US stocks and US bonds?  Someday, something will do just that.  The question for traders is...do you think the regime just shifted.

    Personally, I'm not convinced, and so i faded this move at the close by selling ES and ZN  (S&P futures and 10yr Treasury futures) at a ratio of 4 ES vs 11 ZN contracts.  If you are trading a 1mm$ account and wanted to put 1/3 of your margin to work on this leveraged trade, then you would sell 40 ES @ 1555 and sell 110 ZN @ 132-26 (thats 317k of margin...so 1/3 of your futures account as an example).  The trade to fade this move is to sell both (sell ZN and Sell ES), which is exactly what I've done.

Follow @govttrader on twitter to see what happens with NFP and next weeks long end (10yr and 30yr) treasury auctions.  Did the regime just change...or did the mkt just provide me a gift?   My expected timeframe for this trade is 1-2 weeks.  As always, my expectation for the future will determine when i actually exit this trade.

Disclosure:  I am not advising anybody do this trade with me...this is a leveraged trade, and short positions have the theoretical potential for unlimited losses.


govttrader out...

Stock vs Bonds (and trading other correlated assets)

I get asked a lot of questions about how i measure 10yr yields vs ES to get a RV valuation.  I think i've posted the details on this blog in the past....so here i'm just talking about the basic premise...when you want to trade any pair based on a historical relationship.


When you think 2 securities are correlated..the first thing you normally do is ask...how can i tell if this is true?   The first route is to take prices, and graph them over some time interval (5 min, hourly, daily, etc...).  In this case, i took closing ES prices and 10yr yields.  I noticed that if i look from June 2012 to the present..there seems to be a tracking relationship...but with some deviation.  This is exactly what we want to see in a correlated pair...basic tracking...but with enough slippage that the pair mean reverts over time to some "fair value" (both towards and away from...ie...it gets both rich at times..and cheap at other times).  I know from experience that the treasury mkt tends to selloff or weaken between the start of the month and  long end supply (10yr and 30yr auction supply concession).  I also know that treasuries tend to richen towards the end of the month (the month-end extension trade).  When i looked at this pair graph, and overlapped these time frames..lo and behold...this tends to be true...not always to the exact date...but generally speaking.  So taking a few basic measurements and some time in excel...aong with a few assumptions that i had to verify from the data, i calculated that 4 ES contracts vs 1mm 10yr notes (or 11 ZN contracts) gave me the correct PnL graph to match the graph of the securities levels (after adjusting by a factor to put them in consistent terms).  You can do this yourself if you spend some time in excel with the historical data.  Then to answer the question "are treasuries rich or cheap vs stocks?" you can look at the graph and put the pair in historical context.  I take this a step further and add a "fudge factor" to center the bulk of the historical distribution at zero...the highest and lowest points on the graph are not exactly equal distant from zero...but pretty close.   Then i measure the distance from the point i've created as my "fair value zero" to the current mkt level...and violla....rich/cheap.  While you could just as easily be measuring the rich cheap of ES...the UST component tends to be the more volatile component...and thus the one i've chosen to base my measurements.  I could just as easily be saying that ES is 65 pts too rich vs where treasuries are trading right now...but since i more often just trade the bond leg on its own...i prefer to quote in terms of UST..so basis points (ie..if the 10yr were to selloff 13 bps right now..and ES didn't move...then i would say both are priced at fair value...alternatively..ES could selloff 65 pts and 10yr yields not move...and i would also say both are priced at fair value...given the last 9 months of this relatonship).  This is not rocket science...just lots of basic graph interpretation and some basic math...combined with my intuition of what i expect...backed up with 9 months of mkt history.


If you do this exercise yourself (be prepared to spend some time fiddling in excel and playing with fudge factors to define the relationship)...you should find that the spread between ES and 10yr yields looks almost like a sin wave (from geometry...sin / cosine / tangent...remember those days??).  That is a perfect example of a mean reverting relationship if you ask me.  And since this is trading..you really never get perfect.  If you look back pre-June 2012...this relationship breaks down.  I haven't spent the time to figure out what the relationship was back then...but i can say with certainty that the regime shifted in the 1st half of 2012...and the resulting regime gives us this nice relationship to trade.  I'll take it for as long as it lasts...and then when it breaks down (which it eventually must)..then i'll move on to something else.  Thus is the nature of trading....



I stopped graphing the relationship back in January...since i built a realtime trading system and i'm involved in trading this everyday, i don't need the graphs anymore..so i stopped updating it...but if you do the work you should be able to reproduce what i have and then fill in the blanks for the more recent time period.

govttrader out...

Post-Mortem from yesterday in pictures

Presented with minimal commentary.

Just a quickie - 30yr bond auction stat

That stat we've talked about every 3 months...its back...now 16 for 16 (still shooting 100%)...new 30yr bonds followed by rally where bonds purchased at auction can be sold within 24 hours for greater than 20 ticks of profit (in this case..12-15 hours was the sweet spot).

see you in 3 months people....govttrader out

UST 10yr Auction Post Mortem

That has got to be one of the least volatile 10yr auctions i've seen in a long time.   From yesterdays close ES is unch and ZN is 12 ticks lower.  The stats and just about everything else about this auction are quite unremarkable.  Dealers took 47.7% of the auction, directs as has recently been the case ended up with a sizable 24.2%, while indirects took only 28% of the auction.  I am interpreting the 1bp tail as the curve concession that the RV traders were unable to recognize in the setup.  Since cash 10's did not cheapen in the setup...the short base must not have been as large as the market estimated.  All thoughts are now focused on tomorrow's 30yr bond auction..and here is my take of the price action (or lack thereof) that the 10yr auction has provided us.  While total volumes for the day seem only slightly lower than "in line" with a 10yr auction day, we must presume that there was enough short covering clashing with "last minute setup"  pre-auction to give us this 1bp tail result  (a very large short base would have resulted in a thru result)....net-net, the market does not seem to have a leveraged position one way or the other (i would skew to the mkt being small long given the post auction price action).   This argues even more strongly for a 10/30 steepener as a setup for tomorrow's 30yr auction, if you can get it on south of 120.2, as well as continuing to sell pops in the 30yr overnight.   With very little volatility post auction (mkt leaking lower), the positioning report is harder to create...which again argues for a fairly flat to small long position assumption.  With the market just sitting around the auction stop and any trading taking place not able to move the needle more than 3 ticks price-wise...i imagine that i am not the only trader thinking these thoughts (sell pops...and put on a steepener to setup for tomorrow).  Also, coming out of tomorrow's 30yr bond auction...i want to enter into a long UST / long ES trade from north of 15bps cheap (13 bps cheap as i write this). 

The relationship vs ES is a great way to gauge how an auction setup progresses.  Today, the range was 10 cheap to 13.5 cheap.   I would expect an opportunity to sell this spread north of 14-15 bps before the 30yr bond auction tomorrow.  While the long end auctions are not always the best opportunity to trade this spread...the recent cheapening of UST makes this spread attractive to short imo. We have not seen the large leveraged trader recently...rather, the market has simply built value concensus at lower and lower prices.  This makes sense as we are in the midst of the long end auctions.  How the market trades coming out of tomorrow's 30yr bond auction will be the best piece of information the bond market will have had in a long time regarding the macro direction of yields. I would not be surprised if we visit the lows made overnight Monday Feb 4 and the bounce out.  However, that is looking too far ahead.

govttrader out...

UST 10yr Auction Preview

Today's 24bln 10yr auction will be an interesting event in the treasury market.  Normally, issues being auctioned have both a curve and outright concession going into the auction (market participants sell the on-the-run issue to be auctioned in the secondary market, and cover that short in the auction).  On the margin, this has not happened heading into today's 10yr auction.  In fact, 10yr notes have richened as the setup for this auction has progressed.  This makes sense from an RV perspective (cash 10yr notes are very cheap on the 7-10-30 fly, so RV traders should be buying them vs 7's and 30's). Normally this RV trading behavior would take place AFTER / DURING the auction, rather than before, so the only concession we have going into today's auction is outright.  The treasury market has traded lower consistently over the past 3 days, and each time the selling was both auction setup related, as well as induced by the grinding higher nature of the Stock Market  (note - ES has continued to grind higher while consistently respecting its 3 month channel).  The bonds vs stocks model has been fairly range-bound...tending to bounce off any richening moments (my model now reads 10yr notes are 11bps cheap vs ES on the 7 month timeframe...and only 1 bp cheap on the 2 month).  I would read the outright concession on the 10yr note at about 5 basis points (would be 6-7 bps without the RV fly traders getting in the way).   With ES looking to stabilize around 1516-1518, it looks like the treasury market doesn't need to worry about an ES selloff in the next 30 minutes to create panic short covering.  The short base for the auction seems fairly well set, and i'd estimate the avg price of the short base to be around 131-17 in ZN....or 97-30 on cash 10yr notes.  So long as we stay below there (99% chance by the looks of it) this auction should go off without a hitch.  The tail / thru prediction for this auction is less certain.  We are 7 ticks off the low in cash 10yr notes...so any tail would probably come somewhere between here (96-20+) and there.  On the flip side, strong RV demand adds another set of auction buyers to consider.  As i've mentioned previously about before new 10yr note and 30yr bond auctions, over the past 3 years every new 30yr bond auction has seen rallies post auction 100% of the time.  Given that UST are trading on the cheaper side of the stocks vs bonds relationship, and we have seen "enough" of an outright concession...i don't see any reason for this cycle to be any different.  Dealers most likely want to come out of this auction long 10yr (both outright and on the curve).  I plan on using today to put on 1 unit of 10/30 steepener for the next 12-24 hours...and will look to add if we see more flattening after the auction.  I want to come out of the 30yr auction tomorrow long and in a 10/30 flattener...but we will have to see what the price action allows.

If today was the 30yr auction...i would be all bulled up to buy the auction and come out long given the price action.  Perhaps i'm not alone in that thinking..which will gravitate the auction to come on the screws @ 2.04

---In summary---

pros
-5bp outright concession in place
-UST are 5-10 bps cheap vs stocks


cons
-no curve concession
-US stocks have been grinding higher showing no signs of topping

I don't expect a tail.  Most likely we come on the screws to small thru.  I'm now in buy dips mode for UST...and i want to put on a 10/30 steepener...hopefully the price action post-auction allows that.

Advice for a trader

I've read blog posts and articles with similar titles to this one, but today, after receiving multiple questions from traders about my methods, i thought i'd take a shot at giving it my own 2 cents.

This is partially my way of responding "en-mass" to people who have emailed me..and partly a "note to self" for future reference.

When I am trading, setting levels, buying the market because i think it will go up, selling the market when i think it will go down, exiting to take profits, getting stopped out because i was wrong, either in my target level, or because the market went right thru my entry and just kept on going, I am not simple expressing "what i think will happen and taking a shot."   The market doesn't care what i think (unless i was trading the fixed income portfolio at PIMCO or SAFE...which i'm currently not).  But more importantly, I am taking positions that i think have the lowest likelihood of losing money, while attempting to also take as many of those positions as possible, with clear knowledge of how to determine if i'm wrong as soon as possible.  My primary goal is not to make as much money as possible (well, it is, sortof).  Rather, my intent is to not lose any money.  If I can take positions and not lose, then the profits will just come.  This is of course contradictory.  The best method to "not lose any money" is simply not to trade.  So, unless i have a good reason to put a position on...thats exactly what i do...i don't take a position.  Some days i'll put on over 15 trades...some days not a single one.

The point is that "taking a stab" does not fall into the "lowest likelihood of losing money."  Today, i talked about 2 explicit trades over twitter.  The first was buying a dip below the bottom of the bell curve in what appeared to be a random market move on economic news out of Europe around 4am EST.  The 2nd trade was hopping onboard an observed momentum move with a market technical reason combined with the volume momentum between 12 noon and 3pm.  Both of these trades had both technical and qualitative reasons to argue for why they had low probabilities of losing money, and both were clear patterns that i was attempting to join.  Both of these trades also had quantifiable signals to indicate if i was wrong.  I could have held onto both trades and waited for them to be profitable and been "patient"  (sometimes also referred to as stubborn).  Had i done that, I would have gotten killed.  I took a small loss (-5 ticks) on the first trade after my reason for the trade was violated (being patient here would have cost me an additional 11 ticks asof the close), and the 2nd trade played out exactly as i expected (+8 ticks) (actually, a little better than i expected...but my nervousness brought me to exit the trade early in an attempt to be "cute" and missed out on an additional 6 ticks).  I'm not trying to be a hero, and I will almost never be the one to call the top or bottom of a large volume move.  My best and most profitable trades take place after identifying a pattern and joining the pattern at an entry price as close as possible to my stop-loss price.  Occasionally (rarely) I get the chance to be onboard a move before it gets qualified as a large volume move, and I try for these every chance i get.  However, i never expect to call the top or bottom of a large volume move.  I expect to miss the tip top, and the low tick bottom.  Anything else seems folly to me..because neither PIMCO, SAFE, or the other multi-billion $ levered funds give me the heads up...and i don't think you should expect them to either.

So, what am i left with?  2 words:  Pattern Recognition.  The human brain is extremely adept at recognizing patterns.  The trick to using this skill (and almost all traders have it) is to spend the time, put in the work and watch the market (like, every tick) until the pattern becomes clear as day for you.  Only then, can you take a position to take advantage of the pattern.  The true value of this approach is, if you are positioning for a specific pattern and you put in the work, you will clearly see if the market behavior deviates from the expected pattern.  If it does, then you exit the position as the pattern has been broken, thereby invalidating your trade thesis.  You then go back to work, watching the market, looking for the next pattern to "appear" to you.  This might happen 30 seconds after you get stopped out of your previous trade, and it might not happen for the rest of the day.  The point is that trading liquid markets takes a combination of discipline, focus, hard work, and excruciating attention to detail.  Even if after putting in all this work, some people aren't cut out to be traders, usually because they are unwilling to follow the rules.  If you are constantly getting stopped out after doing all the correct "work" then the most likely explanation is that you are trading patterns that don't really exist.

This is my trading "style."  There are other styles, and they all require different skill-sets.  My style revolves around the precept that I have identified a set of patterns (not just simple price volume patterns, but patterns that involve a multitude of factors).  Every trader has the responsibility to find their own patterns (whatever that means to you) and trade them accordingly.  If you aren't willing to do this, then you should not be surprised if the market takes all your money.  Some traders will get lucky and make a lot of money...and its true...being lucky is better than being good...but for those "unlucky" ones out there, this is the only way.

So, in conclusion...size your risk units accordingly for your system of patterns, keep your emotions in check,  and be patient yet fierce.  As Sun Tsu said, "the time to strike is when opportunity presents itself"

govttrader out...

Best Trading Strategy Of The Week - Still Buying US Treasuries On Dips

If you are following govttrader on twitter, you already know the story.  Yesterday afternoon the market shifted value in US Treasuries higher, again.  Using 10yr Treasury futures as our reference point, 132-28 became the center of "value" yesterday (Thursday)...after the center of value originally being 132-16 on Wednesday. 

So, last night, I bought ZN @ 132-24 (documented on twitter), and this morning, sold my ZN to get flat at 133-02 (also documented on twitter) (twitter is the first place to get this info, so please subscribe to the govttrader feed for free). 

The Treasury market is again seeking a price level where buyers and sellers can agree for a period of time so they can transact significant volume just like any normal day (thus far, trading volumes have been pretty slim...but price patterns have been consistent with normal trading cycles).  The problem with this thinking is that we have month/year-end approaching, and there are people who MUST BUY Treasuries.  I'm talking about people who job description includes "purchase US Treasuries at the end of the month."  Unfortunately for those people, their job description is not a secret.  Front-running is illegal in the stock market...but...buying ahead of publicly known buyers....that is not illegal.  There is no guarantee that the price will go up..but trading is not about guarantees.  Trading is about managing your risk, and trading strategies that have a high probability of being profitable if pursued often enough (sort of like being the house at a casino).

I don't have much "new information" to add to the dialogue at this point.  Yesterday's govttrader article was pretty clear, and the twitter stream has all the relevant trading info.  Let this serve as my first public plea for all you traders out there (not investors..traders only) to follow along on twitter and create a dialogue.  I'm open for questions.

Oh, and by the way...the trading strategy is still "buy the dip".

govttrader out

Treasury Selloff Exhaustion Has Reversed - Next Stop - Month / Year End

2 days ago we talked about why US treasuries were cheap (both on an outright basis and on a relative value basis vs stocks).  While I make no prediction regarding the direction of the stock market (Tyler @ zerohedge gets all the credit for that), US Treasuries have outperformed both on an outright basis as well as on a relative basis vs stocks from Tuesday Dec 18, just as we thought they would.  On the blog we talked about using the bell curve and market profile to determine the best location to buy US Treasuries to leg into this trade, and yesterday afternoon / last night we got our perfect buying location (132-03 / -04 in ZN).

given the new 132-12 local high in ZN overnight...the bottom of the 1st bell curve is now 132-03...so that's where I will try to get long
— govttrader (@govttrader) December 20, 2012

So that's all history now...what to do next?

While I expect US Treasuries to outperform stocks and continue to rally up through month / year end, that doesn't mean i want to just stay long and expect treasuries to move up vertically.  Like everything else in the markets, nothing moves in a straight line.  My bias is now to be either long UST (buying on dips) or flat (sell pops).  There can still be some value in getting flat UST on pops, and then re-buying on dips, but we must be careful to watch how much volume trades in the screens so we don't miss the coming undersupply condition (the rare instance where we do get vertical price action after a large buyer asserts their position).  The bell curve and market profile will be our guide for these levels.  I'll be updating thoughts on these ideas and levels on the embedded twitter feed on the blog.

govttrader out...