Thursday, September 13, 2012

What does "be afraid" mean today?

A number of people have asked me...what did i mean when i said "be afraid"? 

My meaning is thus...dealers are required to bid for their pro-rata share of the 20 primary dealers and 13bln bonds being auctioned..each dealer is required to submit bids for 1/20 * 13 = 650mm bonds.   If everyone goes into the auction short bonds (it certainly feels that way), and many of these participants choose to "bid thru" to cover their short position, then the probability of the auction "coming thru" (also referred to as "stopping short") gets pretty high.  In these instances where the auction comes thru, participants who sold the market just before the auction and cover in the auction lose money (the difference between their avg short cost and the auction stop).  Most participants who go into an auction short submit "thru bids" to ensure they don't miss the auction (they do this because in a Dutch auction, everybody gets the same auction price...thus the potential for a tail).  In cases where this happens, there are usually some traders who "missed" the auction, and they tend to scramble to buy bonds in the secondary market.  These types of misses can be very costly, as the 30yr bond can get very jumpy when the market feels a short squeeze coming.  This type of price action (lots of selling pre-auction) is great for prop traders who don't actually bid in the auction...but trade the setup, get flat for the auction, and trade the post auction price action instead.

I'm not saying this auction will stop short...i'm simply saying that the outcome of the auction is a gamble with  hard to predict outcomes...and if your short position was not established from much higher prices...then you are playing with fire bidding in the auction to cover your short.  If the auction comes thru 3 basis points (not uncommon) thats roughly 21 ticks...which tends to sting if you don't have a chunk of change in the bank.

The main purpose of this blog is NOT to try to call every move in the market.  Rather, the purpose is to identify high probability trading opportunities with low risk vs high reward scenarios.  Bidding in today's auction to cover a short is not low risk.  I would call it high risk / high reward.  Now, if the auction tails (a dealer dream) then the secondary market usually provides a chance to buy bonds close to the auction stop shortly after the auction.  This is not always the case..but it happens more often than not.

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