Friday, May 1, 2009

How To Trade Interest Rates

When I tell people that I trade bonds, their reaction is usually, "how boring." But the truth is, after more than 30 years of being a financial market participant, there is nothing that I enjoy working with than bonds.

Granted, there are times when I don't understand why bonds do what they do, but I always trust the bond market. It is Global in nature and trades almost 24 hours a day. Even the effects of attempted market manipulation by the Federal Reserve was short-lived. While interest rates dropped dramatically on certain Federal Reserve announcements, the Treasury markets soon shrugged off fears of intervention.

While many understand bonds to be a less volatile component of a portfolio and because of this "boring," this is no longer the truth. Bond moves have been dramatic in some cases. Double digit gains and losses on certain corporate bonds are not uncommon. You don't need to be a millionaire to win big or lose big in this market though. This is because both interest rates and govenment securities can be traded on derivatives exchanges.

My blogs include charts on both the TNX, the ten year note rate index as well as the futures contract on the 10 year notes. These charts are somewhat inverse of each other because as interest rates rise, notes and bond prices fall. Because of this, you can always find a bull market here. Notice above, the ten year rate is rising, breaking above the 3% level. While you can't go out and tell your broker to buy you 100 shares of TNX, as it is an index; you can trade this index with Options. Options are exchange-traded vehicles which give you the right to buy or sell the TNX at a set price in the future. Thus, you can profit from an increasing interest rate by buying a call option. Because options are rights to buy or sell, the amount of money you put up for this right is a small fraction of the price of the underlying index. Thus, if you are right in both timing and market movement, you can win many times the amount of money you bet.

Another way to participate with the US Government market is through exchange traded futures contracts and options on the futures. What makes futures attractive is that your leverage is further enhanced. To participate in the 10 Year Treasury futures market, your exchange margin requirement is less than $3,000. If you put up $3,000, you can enter into a futures contract representing $100,000 in government notes! Each point that the note futures moves is equivalent to $1,000. Notice the chart below to see how many points a note futures contract can move in a week!

If you are wrong, you can lose your $3,000 AND MORE, very quickly but if you are right, the profit potential is enormous. As such, you should make sure that you only work with risk capital that you can afford to lose. You should also be sure that you have sufficient capital in your account to cover any losses that may result while you are waiting to be right. My rule of thumb is having at least $10,000 in capital for each note position I hold. Having adequate funds available is the key to being successful in the futures market.
Markets being what they are, you can never expect to be right immediately. The market doesn't work that way. Often, one must be patient to realize gains. If your capital is limited though, you cannot have the patience to withstand a move against you. As a result, undercapitalized futures traders usually wind up losing everything. It is the market that generally dictates when they most close their position, usually at the worst possible time.
Boring? I don't think so.
Keep in mind, futures and options can also serve to help you manage your risk. You can use futures contracts with your stock market portfolio to shift your asset allocation without actually buying or selling any additional shares of stocks or bonds. If you fear a market meltdown, you can use the futures market to totally hedge your market position, allowing you to "sit it out" for awhile.
Be wary of those Socialists who bash speculators. Without speculators, there could be NO RISK MANAGEMENT for others. It is the speculators who are willing to take the risk that others don't want. Without them, prices of everything would be higher. Please let the markets work!

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