A Flexible Way to Trade on Economic Reports

By Bensman, Miriam | Modern Trader, July 1994 | Go to article overview

A Flexible Way to Trade on Economic Reports


Bensman, Miriam, Modern Trader


Want to set yourself up in the market for when big government reports are released? The new Flexible Treasury Options allow you to place short-term options of varying expirations or strikes. The key is pricing. Here's a way.

Bond traders live and die by the numbers: the economic statistics that provide inklings of whether inflation is likely to drive down the value of their holdings, and whether it is greater or less than previously feared. But trading on those numbers or managing risk around them is far from efficient in the options pits. Hedging a one-week exposure with a quarterly option doesn't make sense. Neither does betting on a number one week out using quarterly or serial options.

That's a key reason many traders have long directed their announcement-day positions to the over-the-counter market. It's also a reason many traders are turning to the Flexible Treasury Options introduced on the Chicago Board of Trade (CBOT) in January.

So far, the lion's share of the new product's activity has been short-dated, as proprietary traders from banks to hedge funds have piled in to trade on economic announcements. In one 16-day period, a CBOT study found, fully one-third of all requests for quotes were for options with just one day to expiration, and 45% had one week to expiration. Only 12% were for more than four weeks.

Annualized historical volatility
January 1991-January 1994

                                   Ten-         Red
                      Bond         year        Euros         DM       S&P

Non-farm
payrolls              12.3%(*)     8.9%(*)     44.6%(*)     16.2%     10.0%
CPI                   10.5(*)      6.6(*)      24.5          9.3      10.1
PPI                   10.2(*)      6.4         26.9         15.6      10.3
Real GDP               9.8(*)      6.7(*)      24.4         12.8       7.5
NAPM                   9.6(*)      7.0(*)      26.1         14.6       9.8
Retail sales           8.0         5.6         27.9         10.5      13.5
Trade deficit          7.8         5.1         20.9         15.1       9.7
Durable goods          7.2         4.8         18.4         11.5      10.7
All other days         7.0         5.0         19.8         12.5      11.0

* Indicates difference between announcement day historical volatility and "all
other days" historical volatility is statistically significant at the 0.025
level.

Source: J.P. Morgan

Pricing matters

But short-dated options are difficult to price correctly, because implied volatility varies widely day-by-day. Announcements of non-farm payrolls, for example, are well-known to rock the market -- one way or the other.

"There's a different volatility on event days -- those with economic announcements," says Terry Belton, head of research at J.P. Morgan Futures. "There's also a different shape to the distribution."

The variability of volatility doesn't matter too much when you buy long-term options, because most months and quarters have roughly the same number of scheduled economic announcements. But if you buy a one-day option, there may be a slew of announcements -- or none.

Belton devised a model a year ago to price event risk in Treasury bond and Eurodollar options. Initially used to compare values in the listed and OTC markets, the model became key to Morgan's proprietary trading and brokerage in Flexible Treasury Options.

How it works

Interest rate volatility is predictably higher on some economic announcement days. In the three years from Jan. 1, 1991, to Jan. 1, 1994, the average annualized historic volatility for T-bonds was 12.3% on days the non-farm payroll figure was announced, compared to 7.2% to 10.5% on other key data days and 7% on all other days, a Morgan study found. Similar results are true for the 10-year note and Eurodollar options -- but don't hold true for the S&P 500 contract.

Equally important, the distribution of price changes on payroll days is far from normal: It's rectangular, and the tails are fatter. …

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