Wednesday, April 9, 2014

Last Night's GovtTrader Newsletter

This is the GovtTrader newsletter sent out to subscribers after the close on Tuesday, April 8.
Annotations made after the fact are in italics

Since NFP we've seen some wild moves in the capital markets. 

In the treasury market, we've seen 3 consecutive days of bullish price formations.  First we had a "P-up" formation on NFP Friday, and then we've had 2 days of buy imbalances.  A buy-imbalance is simply a day where the profile looks like a bell curve, but we know that the majority of activity was buying.  If the market price eventually falls back down below the mode, then we call that day a "non-facilitating" buy imbalance ("they" tried to buy the mkt to get the price high, but price falls back down) (that would be bearish).  If however price stays in the upper 50%, then we just call that day a buy imbalance .  If price moves vertically away from the mode and stays in the upper 1/3rd of the range, then we call that a P-up day (and also a buy imbalance).  It could be argued that today was a P-up (tho the shape of the px action was more diagonal than vertical....suffice it to say, today is a buy imbalance formation).  With 3 bullish formations in a row, treasuries trading near the "cheap" end of the range vs USD/JPY, and the 10yr auction tomorrow, the stage has been set for a short covering rally.

1)  We know from the JPM survey that there is a large community of shorts, plus a new community of freshly initiated longs. 
2)  We know from the trading volume yesterday and today that the majority of those shorts have not covered. 
3)  We know that going into the 10yr auction short and bidding to cover is a common strategy. 

So, the mkt will most likely be going into the 10yr auction tomorrow with a large short base.  If the 10yr auction comes strong and many of those shorts don't get to cover their shorts in the auction (what we call "stopping short") (which is what i expect), the post auction px action should be a high volume, high velocity, high volatility short covering rally.

There are a couple ways to play for this type of short covering rally (you can just go into the auction long 10yr futures, or you can buy in the mkt after the auction after the 1st repricing and give up the auction surprise), however there is another way.  Implied vol in the ZN options mkt is on the low end of the historical range @ 4%  The 124.5 1-week ZN Call option (1/2 a point OTM) was 2 bid, offered at 4 today.  This option expires Friday so only has 3 days remaining to expiry, which is why it is so cheap.   

These options were offered @ 2/64ths on the morning of April 9, and traded as high as 5/64ths during the short covering rally today.  ZN traded up to 124-08+ during the short covering rally which took place after the FOMC minutes.  I bought these options @ 2/64ths, and sold them at 3 & 4/64ths
I expect ZN to ease off the highs of the day, and return towards the 123-25 mode at some point between tonight and tomorrow (the low was indeed 123-23).  This should reduce the px of this option by 1/64th.  So, if i can buy this Call option @ 1-2/64ths, i plan on spending 1-2% of my AUM to buy it.  If we get the short covering rally that i am playing for, then ZN can trade above 124-16, and this option should trade above 10-12/64ths.  (i was the first bidder for this option @ 1/64th all day, but they never traded...the high ZN price in the following overnight session was 124-17)
This is the most focused and low risk vs potential reward strategy that i see in the mkt from the current environment.  There is always the risk that we don't get the short covering rally and this option expires worthless. However, that's not what i *think* will happen.
Since this option is trading so cheap, we get a lot of leverage for a limited amount of capped risk.  I am quite honestly surprised these options are trading so cheap...but that's why they call it a market.
Statistically, the NFP move is a fade, and i suspect that is why vol is so cheap this week.  However, i think the mkt has set itself up for an outsized move, and i want to position myself to take advantage of the potential situation.
If implied vol was expensive, then i would sell ATM Puts, but vol is cheap, so selling options doesn't seem like the best strategy to me right now.