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Bond trader reaps 2,000 percent profit just by trusting the Fed

Bloomberg logoBloomberg 5/25/2018 Edward Bolingbroke

The bond market has an early candidate for trade of the year: a 2,000 percent gain on a eurodollar options position held for just four months.

But the most staggering part might be how easy it was to see coming. After all, the wager boiled down to a simple philosophy of trusting the Federal Reserve.

Remember, at the start of the year, bond traders were far less confident about the central bank raising interest rates. For 2018, they had priced in just 50 basis points of tightening, or two hikes, even though Fed officials’ median projection was for three. Some banks, including Goldman Sachs Group Inc., even called for four moves.

Seeing an opportunity, someone in January executed a 100,000-contract block trade in a bearish “risk reversal” bet across March 2019 eurodollar options, which targets a more hawkish Fed policy path. Activity in the wager ramped up over the first quarter to leave a position of about 300,000 contracts, according to traders in Chicago, London and New York familiar with the transaction.

In other words, the owner of the position simply took the Fed at its word and bet against the shallow hike projections priced into the market. To do so, the trader bought a put spread option on March 2019 eurodollars, partly funded by selling a call in the same expiry.

a screenshot of a video game: In the (Big) Money© Bloomberg In the (Big) Money

The 100,000 contract position came all from one trade at just half a tick, meaning the person paid a $1.25 million premium. The bet was being unwound last week against a market level of around 11 ticks, the traders familiar with the transaction said. That markup equates to a 2,000 percent return. If the entire block was liquidated, that would result in a $26 million profit.

Just as the timing of getting into the trade proved prescient (overnight index swaps were pricing in close to four rate hikes for the year as recently as last week), so too was the decision to book profits.

The beginning of the unwind came ahead of Wednesday’s release of minutes of the Fed’s May meeting, which revealed that policy makers were discussing a potential cut to the interest on excess reserves (IOER) rate. That helped spur a short-end rally, which would have eaten into the trade’s gains.

a screenshot of a video game: The Great Unwind© Bloomberg The Great Unwind

In a sign of how aggressively the positions are being unwound, the open interest across the three option strikes has plunged. On each of the puts, at 97.50 and 97.375, the amount of risk has dropped about 50 percent, while the call at 98.00 has fallen 35 percent from February’s peak levels, according to data compiled by Bloomberg.

From the start, the trade had the look of a sure winner. The only time it was in jeopardy was during the early February volatility panic.

Those traders who trusted the Fed -- or even just their in-house calls -- shouldn’t have thought twice about jumping into this cheap bet. Those who did are now reaping the rewards, and can make a credible claim for the best bond trade of 2018 to date.


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