Short-term interest rates are near eight-year highs as we head into what appears to be an inevitable December rate hike by the Fed. On the contrary, interest rates on the longer end of the curve continue to be lofty based on historical standards. The trend might continue, but we see several signs that suggest it probably won’t. The laws of gravity suggest one end of the curve or the other will need to adjust.
In our estimation, it is likely the short-term interest rate securities that will need to move higher in the short run to steepen the yield curve. In other words, we think short-term interest rates will soften in the coming weeks or months. Long-term investors might consider locking in the jump in rates by allocating idle cash to short-term securities, but active traders might consider a speculative play.
Futures traders often speculate and hedge short-term interest rates using Eurodollar futures and options traded on the Chicago Mercantile Exchange (CME). Click here for info on the Eurodollar suite of products. For those of you who have never traded Eurodollars, it is the deepest (most liquid) futures market in the world. It is also probably one of the slowest-moving and lowest-margined contracts on the board. However, if you happen to catch a move at the right time and in the right direction, there is some money to be made. Conversely, the risk is relatively low when compared to most futures markets, and so is the margin.
Seasonally, Eurodollar futures have had a tendency to bottom out sometime in November or December (this means short-term interest rates generally move lower during this time). On some occasions, the bottoms have been sharp and followed by significant rallies. Given the current environment of complacency in the financial markets and the fact that market participants have priced in a December rate hike in addition to a 75% probability of another by June, we are inclined to believe sentiment will likely change between now and then. As we have witnessed on multiple occasions in recent years, the market and the Fed aren’t always on the same page. In short, even if the Fed does, in fact, raise rates on two occasions between now and June, the opinion of the markets and, therefore, asset prices will fluctuate as speculators’ opinions sway back and forth.
When plotting the June 2018 Eurodollar on a chart, we can see the market has a good chance at finding a low somewhere between the current price and 98.05. However, we also acknowledge that holiday markets (between Thanksgiving and New Year’s Day) can be erratic and irrational. Thus, we cannot rule out a quick probe beneath 98. Thus, we like the idea of going long a futures contract and purchasing catastrophic insurance just in case the Eurodollar market comes down with a case of the “holidays.”
Specifically, we like going long the June 2018 Eurodollar future near 98.16 and then purchasing a June 2018 98.00 put for insurance purposes at a cost of about three points (or $75). Insurance is optional but cheap and probably worth having due to the uncertainty of holiday trading. This limits the total risk on the trade to roughly $475/$450 depending on fill prices (plus transaction costs). The max loss would occur if the June Eurodollar was below 98 at expiration. The margin requirement for this trade is extremely low at $250 per contract (even less if you opt to purchase the catastrophic insurance).
The profit potential is theoretically unlimited, but we suspect the upside would be limited to 98.40/98.50, which would produce a profit of $600 to $850. Because the purchased put option is cheap and deep out of the money, it won’t weigh on the trade should prices move favorably.
In conclusion, this is a great example of how the futures markets can provide speculators with low-risk and seemingly high-probability trading ventures. Unfortunately, too many investors and traders are put off by the reputation of high leveraged futures trading without taking the time to consider the fact that the futures markets don’t have to be riskier than any other asset class if proper strategies are employed. It is the trader who ultimately determines leverage and risk, not the exchange. I talk a lot about the concept of deleveraging the futures markets to create reasonable risk opportunities in my book, Higher Probability Commodity Trading.