Bond flattener trade
This article will cover the basics of trading bond spreads, specifically the spread. The article will attempt to give you some background on how bonds are priced and the calculations that go into determining proper spread bond flattener trade. Both investors and traders can benefit by watching the yield curve changes, it may just signal your next trade.
In truth, the price-yield relationship of a Treasury security is nonlinear. As yields fluctuate, the DV01 of a Treasury security changes. Exhibit 1 shows the price-yield relationship of a Treasury security as depicted by the curved line.
The bond flattener trade tangent to the curve represents the DV01 of a Treasury security. As yields increase, the slope of this line flattens. This flattening and steepening of the line tangent to the curve illustrates the changing nature of a DV01 and is called convexity.
The more dramatic the convexity, the more a DV01 will vary as interest rates fluctuate. If you wanted to trade bond flattener trade versus each other you would need to either calculate DV01 yourself of find a site the publishes it, that way you can keep correct ratios to benefit the most form yield curve changes.
The simplest way to calculate a DV01 is bond flattener trade averaging the absolute price changes of a Treasury security for a one-basis point bp increase and decrease in yield-to-maturity. As yields fall, modified duration increases. As yields rise, modified duration decreases.
A higher modified duration implies that a security is more interest rate sensitive. Conversely, a lower modified duration implies that a security is less sensitive. The CME Group also publishes bond flattener trade ratio for all the interest rate products based on the current futures contract.
These are rounded bond flattener trade and will be subject to shifts in the interest rate curve, so be aware. The spread between the yields of the same security with differing maturities makes up the basis for this trade, plus the NOB spread is one of the most heavily traded yield curve spreads. When the yield curve steepens, the Year Treasury Note cash yield will fall relative to the Year Treasury Bond cash yield, and the Year Treasury Note futures price will rise relative to the Year Treasury Bond futures price.
Due to the inverse nature between price bond flattener trade yield in Treasuries, the yield spread will increase, but the price spread will decrease as with any bull spread. The converse is true, for a trader that is expecting the curve to flatten. True yield curve spread filters out directional effects, changes due to parallel shifts in the yield curve, and responds only to changes in the slope of the yield curve or non-parallel shifts. The goal is to filter out directional effects and design a spread trade that will respond only to changes in the shape of the yield curve.
NOB Spreads are usually traded as ratio spread. This ratio bond flattener trade the dollar value of a 1-bp change DV01 in the yield of the shorter-term maturity futures position and that of the longer-term maturity futures position. It is best to trade the NOB in the direction of the prevailing trend, buying weakness at or near support or selling strength at or near resistance. However, a mean reversion strategy can be utilized in a range market. As of January bond flattener trade, for the next few years as long as interest rates are low, you should be able to trade the spread by buying any dips as rates start to creep up and the yield curve begins to steepen.
Some platforms support trading a constructed spread, in Interactive Brokers you can build this spread and trade it as a unit.
Exiting is the same process but in reverse. You can choose the front month or make a trade bond flattener trade based on farther out months. A daily chart can be used to identify the prevailing trend, and a 15 minute chart is good for execution. You can see the effect of the Federal Reserve flattening the yield curve since the financial crisis. Below is the spread when I initially wrote this article.
The second chart is the spread approximately 5 months later. Short term rates remain very low. So, which type of Steepener is this? These definitions apply to the NOB spread terminology as well, but you can use them to spread more than just the year versus the year. The 2-year versus the 5-year and the 2 year versus the year can be bond flattener trade trades. The Steepener trade takes advantage of the spread on short term versus long term bond yields getting wider, hence the yield curve is getting steeper.
The bull and bear naming convention comes from what the changes in bond flattener trade yield curve mean to the markets and the economy when pronounced on bond flattener trade the short term end or the bond flattener trade term end of the curve.
For the examples I just used the dates from my yield curve spreadsheet and made up my own rate changes. When the shape of the yield curve flattens as a result of long term interest rates falling faster than short term interest rates. It is called a bull flattener because this change in the yield curve often precedes the Fed lowering short term interest rates, which is bullish for both the economy and the stock market. When short term interest rates rise faster than long term interest rates.
It is called a bear flattener because this change in the yield curve often precedes the Fed raising short term interest rates, which is bearish for both the economy and the stock market.
When short term interest rates fall faster than long term interest rates. This often happens when the Fed is expected to lower interest rates, a bullish sign for both the economy and stocks. When long term interest rates rise faster than short term interest rates. This often happens when inflation expectations pick up, at which point the market may anticipate a fed rate increase to battle upcoming inflation.
This scenario would be be bearish for both the economy and stock market. When I asked you what Steepener I showed above, the real Yield Curve has done a Bear Steepener, in my opinion, as mid bond flattener trade long term rates have risen while short term rates have stayed low. Relative changes may tell a different story.
Some of the more popular ways to trade short term interest rate changes is to bond flattener trade a combination of the 2-year, the 5-year, and the year Treasuries. Here is a paper from the CME Group that bond flattener trade a trade thesis and execution. There is a great deal more to learn if bond flattener trade chose to trade interest rate spreads.
Even if you choose not to trade interest rates and spreads, you should keep an eye on them as they may give you an early warning of market weakness or strength. Treasury futures trade in price, but it is often useful to consider strategies in terms of yield changes, taking into account the bond flattener trade sensitivity of the underlying security.
This Empirical Duration Tool provides a convenient way to estimate a Treasury futures price for a given change in yield. This bond flattener trade is especially useful in developing options strategies, for example, in determining which strike price to choose, assuming the yield move by a given amount.
The Treasury futures roll represents the shift in open interest from the expiring front month quarterly futures contract to the deferred quarterly futures contract e. During the roll, market participants offset existing market positions in the front month contract while reestablishing new positions in the deferred month contract. The Treasury futures roll occurs on a quarterly basis that coincides with the March, June, September, and December delivery cycle of the Treasury futures contracts.
Historically, the roll has occurred over a two-week period that is centered on the first delivery day of the expiring front month futures contract. For 2-Year, 3-Year, and 5-Year Note futures, the roll typically begins 16 to 28 trading days prior to the last trading day in the expiring front month futures contract.
The last trading day for the expiring front month 2-Year, 3-Year, and 5-Year Note futures contracts occurs on the last business day of the expiration month.
For Year Note ZN and Year Bond futures ZBthe roll usually begins 12 to 16 trading days prior to the last trading day in the expiring front month futures contract. The last trading day bond flattener trade the expiring front month Year Note and Bond futures contracts occurs on the seventh to last business day of the expiration month.