Normally, I would have wanted to write after the FOMC meeting, but I do not expect anything earth-shattering to happen on Wednesday. The Fed is data and news dependent, just like the rest of us, and there has not been a lot of “decisive” news the past few weeks. I also have plans later this week and wanted to pass along some thoughts you may find helpful this week.
It’s not clear what the Trading Gods have in store for us the rest of the year. Since antiquity, whenever one needed some enlightenment from above, one went to see an Oracle. In keeping with my post-COVID carpe diem mentality, I decided to finally check something off my bucket list and go to Nebraska later this week to pay my respects to someone I have admired for a long time – the Oracle of Omaha, Warren Buffet. Charlie Munger too. None of us are getting any younger, and we won’t be around forever.
All corniness aside, there is little overlap between what Buffet looks at and what I look at. I’m going more to take a break and get a different perspective – hearing what they have to say on various unrelated topics, being in the same room and absorbing their aura, eating at Buffet’s favorite restaurants, and absorbing the essence of the Buffet/Omaha lifestyle. I find that when I spend time away from the markets, I can focus on more than just the minutiae of what futures structures look a basis point off from fair value. Every once in a while, you need to take a few steps back and assess what is going on in the markets and whether your approach is optimal for that current environment.
POST-MARCH PRE-REVIEW
That March rate volatility explosion caused me to think even more about some bigger themes. In particular:
The past few years have seen relative value trades suffer disproportionately more on some initially large rate moves, before eventually reverting back to fair value.
Part of this could be market-making algos that don’t recalibrate until after a large move.
Another part of this could be large market participants being initially (incorrectly) stubborn with certain strategies.
And another part of this could be the prevalence of “trend following” and other price-insensitive strategies.
In theory, every bullet point describes excellent conditions for relative value profitability. In practice, trading relative value can get tricky because something that has a lot of value can start losing money noticeably before making money.
The 30,000 foot conclusion can only be that this is a highly profitable game. If you can’t figure out how to design a strategy to take advantage of the multiple mispricings above, you probably shouldn’t be trading. Any time you are trading a vehicle that eventually CONVERGES (like short term interest rates) to something (a central bank policy rate in this case), and you have human AND “AS” (Artificial Stupidity) participants that may be sometimes or always be price-insensitive, that can only be a win. As I have time later this year, I’ll discuss some of the issues involved.
VALUE ON THE CURVE
For the rest of my time today, I wanted to point out something I mentioned to colleagues a couple weeks ago: “theoretically, if you knew the July meeting was a constant and no changes to the SOFR/FF fixings (either by Fed or markets), the SR3M3 (June 2023 expiry 3mo SOFR) options should not have a continuous [I meant “bell-shaped”] distribution but a discrete one.” You can start to see this by looking at the various call (or put) flies on SR3M3. I describe how to do this in one of the articles I wrote for the Chicago Mercantile Exchange.
In case you were not aware, the June Fed meeting result comes out 2 days before the SR3M3 options expire. SR3M3 is by definition 100% of the May meeting, 100% of the June meeting, and 60% of the July meeting. We will know 200/260 (77%) of the meeting information you will need to price SR3M3. The other 60/260 will most likely be a small constant (i.e. the markets will most likely price in a “no move” for the July Fed meeting but could add a few bps of a hike or an ease). The only remaining unknown is the relationship between the SOFR fixings and the Fed’s target range. The SOFR fixings have traded in an extremely tight and consistent range to the Fed’s target range for months. While it is possible for the relationship to change (or for the Fed to do something like go to a “point” target), these are much less likely scenarios.
You would expect the “correct” probability distribution for SR3M3 in the near term to be a discrete distribution (multimodal around 25bp wide centers) than a unimodal bell-shaped curve. If you are using Black-Scholes or any other methodology assuming a bell-shaped curve, you may want to reconsider if that assumption makes sense.
Conversely, a contract like SR3N3 (July expiry on SR3U3) has 100% of the July meeting, 99% of the Sept meeting, 53% of the Nov meeting, and 7% of the Dec meeting. We will know NONE of those values by the July option expiry. So that distribution will be more “normal.”
There is still some opportunity in the SR3M3 options, if you have a strong view on the terminal rate before the Fed meeting. You also get another chance on the SR3Z3 options, which also have a set-up where you know the Dec Fed meeting result before the Dec option expiry. This may be why some people in the markets are claiming the implied probability density functions for SRZ3 are starting to look “jagged.” It is SUPPOSED TO look jagged (multimodal around 25bp wide centers) if the January meeting does not have a wide range at the December expiry. SR3Z3 has a 53% exposure to the Jan 2024 meeting. I don’t have a strong enough view right now, but just make a mental note. It is rare to have a year where there are two such option expiry opportunities.
The money is in the details.
Let me know via a “like” on Substack or Twitter (or just an email) if you like this post. Again, if the sum of new subscribers plus likes is greater than x% I’ll write more frequently than my baseline of once a month.
Note that this is not investment advice, you can lose money, I could be a contrarian indicator, all that glitters isn't gold, haste makes waste, and any other saying that may denote the non-seriousness of this post.
Happy trading!
Hey,
Can you give a trade example for the jun or dec options that you mentioned here?
Thanks