Treasury bonds are boring, right? Wrong. For traders, they represent a market that can be bigger than stocks.
For some people, the thought of trading bonds evokes images of Mortimer and Randolph sipping brandy in smoking jackets, or maybe retirees waiting patiently for their biannual coupon payments. Dull, right? But then there are some traders for whom bonds represent the biggest, baddest market of them all—the only one that makes the S&P 500 seem like a pipsqueak. Want to take a peek behind the curtain to see what all the excitement is about?
Bonds don’t have to be a placeholder for your money. For some traders, bonds are just another trading instrument. Period. And for some investors, they’re a default choice for the money you wouldn’t, or don’t, invest in stocks. Cookie-cutter financial plans often suggest you allocate some percentage of your investments into bonds as a “safe” place for your money, no matter what the bond market’s condition. But if you’ve ever seen bond futures trading when interest rates are on the move, you might change your take. Or at least understand the difference between the dynamism of bonds as a futures contract versus the relative safety of bonds as a fixed-income security.
First things first. When discussing Treasury securities, many traders use the term “bonds” as a general descriptor. Technically, Treasury bonds are long-term investments with maturities of 10 years or more. Maturities between two and 10 years are called “notes” and maturities of one year or less are “bills.”
A bond represents debt, unlike a stock, which represents ownership. When you buy a bond, whether it’s from the U.S. Treasury, a corporation, a state, or a municipality, that entity is borrowing money from you and promises to pay you a fixed rate of return plus your money back at some future maturity date. The likelihood that entity will pay you the money is reflected in the bond issuer’s credit rating. Remember when the U.S. lost its AAA rating back in 2011? That happened because people thought the U.S. was a little less likely to pay its promised bond payments. A rating naturally affects a bond’s price and volatility.
Because the rate of return is fixed when the bond is issued, bond prices and interest rates move inversely to each other. Interest rates go up, bond prices go down, and vice versa. If a bond pays some coupon rate, say, 5%, and interest rates drop to 4%, that 5% bond becomes more attractive and people will pay more for it. Remember this inverse relationship between interest rates and bond prices. It’s important because expectations of changes to interest rates can have a big impact on bond prices. And small, incremental changes in bond prices can have a large impact on the yield of a bond. Yield is the bond’s coupon rate divided by the bond’s price.
Bonds also have different times to maturity, ranging from certificates of deposit (CDs) and T-bills maturing in a few months to 30-year Treasury bonds. A bond’s maturity not only affects the rate it offers, but also its price volatility. In simple terms, a bond with a shorter amount of time to maturity—like a 90-day T-bill—will typically have a lower coupon rate than a 30-year bond because people generally require less return to take a risk over a shorter amount of time.
A somewhat more complex concept is the relationship between a bond’s time to maturity and its price volatility. Without getting into all the joys of bond math with modified duration and convexity, suffice it to say that the price of a bond with more time to maturity will be more sensitive to changes in interest rates than a bond with less time. You can see that reflected in the implied volatility (IV) of options on futures for bonds of different maturities. For example, in early 2019, overall IV in options on 30-year Treasury bond futures was 6.4%, and the overall IV in options on 10-year Treasury note futures was 3.5%. They both have the same credit rating of the U.S. government, but the longer time to maturity of the 30-year bond means larger potential price changes, which can translate into higher IV in options on bond futures. When IV is higher, options premiums become more expensive.
With a basic understanding of how bond prices work, you now have to sift through the range of bond and debt products. Most traders and investors generally consider four types:
All of these instruments promise to pay interest and return of your principal at maturity, but they can have different ratings, yields, and maturities. Some are more actively traded than others and offer more flexibility. Foreign bonds aren’t easily traded in the U.S. by retail investors, and they involve currency and political risks that are beyond the scope of this article.
If you ask a trader how bonds are doing today, she'll likely answer with one of two things in mind: 30-year Treasury bond futures or 10-year Treasury note futures. These contracts and their options are the most actively traded bond products for retail investors and traders. Munis and CDs are nice, but when traders trade “bonds,” they're mostly trading bond and note futures and futures options. If you want to trade bond futures, you'll need a futures account. Certain qualifications and permissions are required to trade futures or options on futures (see figure 2 at the end of this article). But any TD Ameritrade client can see futures quotes on the thinkorswim platform. For example, type the root symbol /ZB (for 30-year bond futures) or /ZN (for 10-year note futures) into a symbol field to see quotes, charts, and options. (See figure 1.)
FIGURE 1: BOND FUTURES QUOTES. Pulling bond quotes on thinkorswim is easy. Just go to the Trade tab and type in the symbol (/ZB is shown here). The quote you see is the most “active” futures contract trading. For illustrative purposes only.
When you pull up /ZB on the Trade tab of thinkorswim, it pulls in the quotes for all the bond futures expiration dates, which are always in March, June, September, and/or December. The futures contract that's most actively traded, which is usually the one with the most volume and shortest amount of time left to expiration, is conveniently marked “Active."
Learn the benefits and risks of margin trading.
When you pull up /ZB on the Trade tab, you’ll also see plenty of Treasury bond futures options. The options have different expirations. The options will expire into, and are priced off, the futures contract with the corresponding expiration. For example, April, May, and June Treasury bond futures options expire into the June Treasury bond futures. September options expire into the September Treasury bond futures. The expirations on options are a little funky. Their final trading day is the last Friday that precedes by at least two business days the last business day of the month before the stated expiration month of the options. So June options stop trading on the third Friday of May. Options on bond futures are also American-style, meaning they can be exercised at any time before and including expiration, and are physically settled. That means you buy or sell one bond futures contract for each option that’s exercised or assigned.
One primary difference between bond futures, options on futures, and equity options is point value. You’ll see bond futures quoted in 1/32nd increments and options in 1/64th increments. If /ZB has a price of 145’20, that means the price of the futures is 145 and 20/32nds. An option on /ZB might be “58 bid and “60 ask. That’s 58/64ths bid and 60/64ths ask. You multiply each of those by $1,000 to get the full point value, as a one-point change in bond futures or options is worth $1,000. To clarify further, if you sold a 147 call and bought a 148 call to create a vertical spread in /ZB for a net credit of “22, that credit is 22/64ths, and would generate $343.75 cash in your account. The max potential loss on the trade is the difference between the strikes of one point, which is worth $1,000, minus the credit. For example, $1,000 – $343.75 = $656.25. That’s also 42/64ths times $1,000. So, selling a one-point vertical in bond futures with a max profit of 22/64ths has a max potential loss of 42/64ths (before commissions).
As of February 2019, the margin requirement on each bond futures contract is approximately $2,800. The margin requirement for bond futures is set by the exchange and is subject to change at any time. Note that although the exchanges set the minimum margin requirements for futures, your broker may hold a higher margin requirement if it deems necessary. Margin requirements for bond options use a method called SPAN (standard portfolio analysis of risk), which determines the potential loss of the position based on different scenarios in the bond futures price, time, and volatility. It’s similar to portfolio margin for equity accounts.
Interested in applying for a futures account? See figure 2 below.
FIGURE 2: OPEN A FUTURES ACCOUNT. To apply for futures trading, your account must be enabled for margin, Tier 2 options (Tier 3 for options on futures), and advanced features. To check, log in to your account on the TD Ameritrade website and navigate to Trade > Futures. Take a look at the Getting Started section (highlighted). From there, you can apply for any needed prerequisites or for futures trading.
The strategies you use for bond futures and options can be based on probability and volatility, similar to equity options strategies. Bonds just offer a trader additional trading opportunities, particularly around economic events such as Fed meetings and employment reports. You may be long-term bullish or bearish on bonds if you expect interest rates to decrease or increase over time based on U.S. economic activity, but the 30-year futures typically make enough large price changes up and down daily and weekly to accommodate scalpers and swing traders looking to capture shorter-term moves. But, of course, past performance is not a guarantee of future results. Option traders often use defined-risk strategies such as verticals and iron condors to speculate on bonds going up, down, or sideways. It’s best to keep your position size small while you’re learning to trade bond futures options. They’re actively traded with tight bid/ask spreads, but bonds can move sharply in a matter of minutes.
Whether you’re ready to start trading in the bond arena, or just want to start out as a spectator, get familiar with the bond trading tools on the TD Ameritrade website and the thinkorswim platform and you might find yourself teaching your financial planner a thing or two at your next meeting.
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