A Day in the Life … Of a Bond Trade

Perception is tricky. Reality is better. If you believe bonds are boring, risky, and complex, you’ve got a ton of company among retail traders. In reality, bond futures markets are actively traded, very liquid, have narrow bid/ask spreads, and provide a direct way to speculate on the bond market. Better yet, the value of the bond futures markets equals, or surpasses, equity markets. Great characteristics, all. Since reality is way more fun, let’s unravel the bond market mysteries and some of the mechanics behind Treasury futures.

What Are They?

A Treasury futures contract, like any futures contract, is an agreement between a buyer and seller to buy or sell an underlying at a certain price for delivery and payment at a specific date in the future. With Treasury futures, the underlying asset is a U.S. government–issued coupon security: bonds, notes, or bills.

The T-bond or “long bond” refers to the long-term, 30-year bond (symbol: /ZB on the thinkorswim^® platform from TD Ameritrade). Treasury notes can have 10-year (/ZN), 5-year (/ZF), or 2-year (/ZT) maturities. Treasury bills have shorter maturities of one year or less, but they’re not widely traded.

Interest rates directly affect bond markets, which can likewise affect forex, commodity, and equity markets. For this reason, it’s a good idea to keep interest rates on your radar. And, bond prices and interest rates are inversely related. When interest rates or yields rise, bond prices fall. Why?

To understand this relationship, consider the nature of a bond, which is made up of a face value, an interest rate (coupon), and a maturity date. The interest rate is fixed. So, when expectations change, price is the only thing that moves. If interest rates rise, your fixed-rate bond is now yielding relatively less, so its price has to fall. But this price movement isn’t consistent across different contracts—which can make a bond future complex.

The Value of Price Moves

Treasury futures contracts come in five flavors with different maturities. Figure 1 shows these products and their price movement values. Think of it as a cheat sheet.

Most bond futures contracts have a $100,000 face value. One exception is /ZT, whose face value is twice as much. It has the shortest duration, which means those contracts won’t generally be impacted by interest rate movement. In other words, /ZT doesn’t move as much as the others. On the other hand, /ZB, /ZN, and /ZF are more actively traded. If you bring up /ZB on your thinkorswim platform from TD Ameritrade, and choose to display Active Only, the active contract will be identified.

What’s Your Exposure?

Many traders are drawn to trading futures because of leverage—the ability to commit a small amount of capital to control a large position. And that means small changes in an underlying future’s price could turn into large gains or losses. As with all financial instruments, it’s worth putting in the time to understand how margin and leverage work.

Leverage for futures is different than for stocks. Many traders will let cash-settled futures settle to cash. For physically settled contracts, such as crude oil (/CL), a trader must be out of the position before the settlement date or else a broker like TD Ameritrade, which doesn’t allow physical delivery, will trade out of the contract for you. Futures traders open and close positions before a contract’s settlement date, so they don’t need the contract’s full value in order to trade. (See figure 2 for an illustration of a bond future’s margin mechanics.) Keep in mind: margin requirements are subject to change. So check with the exchange, and/or your broker, before you trade.

Big Doesn’t Have to Be Scary