Risk Management
August 4, 2024 – Weekly comment
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My only real run-in with the risk management department was a long time ago at Refco, and it wasn’t really the risk department, it was the boss of that department, who simply said, “If you’re late on a margin payment ever again, you’re fired.” In those days they weren’t particularly tight on the rules, but even I was smart enough to know a line that could no longer be crossed.
Of course, I have friends who relate vivid stories of risk manager interactions. Invariably, and this is in the old days, it starts with: “And this clown, who doesn’t know ANYTHING about trading, is telling me to exit my position.” The first one relates to a couple of friends making markets in the euro$ option pit, who moved to a new firm. They were bleeding money, and felt the model at the new place wasn’t correctly calculating greeks for the front months. In the conference discussion about pricing models, the risk manager blithely said, “Your guys’ problem is that you’re losing $20 grand a day in time decay.” My friend had to be physically restrained from jumping across the table.
Another one was a friend who was short calls the risk manager wasn’t comfortable with, so the trader bought deep-in calls and sold an equal amount of futures and just pointed to the long calls to explain that he had covered the position, which of course he hadn’t. Bought a little time.
A third friend has the most practical approach. He said that almost everyone at every shop he has ever worked with hates getting a call from the risk manager. Always uncomfortable and adversarial. Not this guy. He says, when I see the risk guy’s number, I immediately answer and greet him like a long lost friend and ask how I can help; “I’d rather have an ally than an enemy in risk. That way he listens to my rationale for the position.”
The reason I mention the role of the risk manager is because of this: the prices in interest rate markets seem COMPLETELY crazy after Friday’s employment report. However, there were a couple of new, high-profile prognostications from out of left field: WSJ’s Nick Timiraos reports: “Citi and JPM now expect the Fed to cut rates by 50 bps in Sept, 50 bps in Nov, 25 in Dec.” Well. That was quick.
What happens now? A lot of risk manager “discussions” about cutting positions. Did it all happen on Friday? I doubt it. Let’s just look at something specific like SFRU4 9550 calls. At the start of the week you could have bought all you wanted at 1.0 or 1.25. SFRU4 had spent the early part of July around 9487.5, then had a nice pop after the CPI report, spiking to 9500. The next couple of weeks were spent between 9490 and 9498.5. Again, the 9550c just languished around 1. On Friday they settled 7.25 vs 9527.5. If I have no position, and walk in Monday, I am a seller at that price. A cut of 50 in Sept would imply ~9515, and absolute certainty of another 50 in November is worth 21 to 22 bps. The Sept FOMC on the 18th is AFTER the option settlement. Contract could MAYBE settle 9540 at the very outside. It’s what we call a gimme. However, we’ve forgotten about the shoulder-tappers. “What if they cut intermeeting?” CUT INTERMEETING ON ONE NUMBER? What are you, a moron? “What if WW3 starts?” THEN WE’RE ALL DEAD ANYWAY.
The question is, has risk been cut enough? The price doesn’t really matter. Because, if you sell these calls at 7, you have to be willing to sell at 10 and higher. Sometimes things just get stupid. Or “weird” to use the new favorite word of the bought-and-paid-for press.
A trade I had flagged as worthy of consideration (I didn’t personally execute any, but a smart guy at RJO got a client involved) is listed below. This traded on July 10, prior to CPI. (Hope you kept it NN!) This what I noted on July 11:
Another interesting curve trade, +10k SFRH5 9600c/-10k 0QH5 9700c for flat. Both calls settled 16.0, but the front is just 47 otm (9553) while 0QH is 73 otm as SFRH6 settled 9526.5. This trade works best on aggressive, forced easing. The roll is a headwind, as Z4 9600c settled 4.25 and 0QZ 9700c settled 9.25. (9520.5/9616.5).
Nice example of using midcurves in a curve trade. Typically they don’t work out like this one!
Here’s the history:
July 10:
SFRH5 9553.0
H5 9600c 16.0
SFRH6 9626.5
0QH 9700c 16.0
Call calendar settle ZERO
August 2
SFRH5 9642,5 +89.5
H5 9600c 57.25 +41.25
SFRH6 9697.5 +71.0
0QH 9700c 40.25 +24.25
Call calendar settle 17.0, while the futures calendar went from -73.5 to -55, a change of 18.5.
Another trade that went through in large size on July 9 or 10 was a buy of 50-60k SFRZ4 9525/9550cs for 6 to 6.5 ref 9520.5. Friday settle, 20.5.
Friend Tim O’Leary has often expressed disdain (yes, I think that’s the proper word) for all those that are trying to peg the near contract with tight butterflies. Had a call fly that tried to peg SFRU4 between 9500 and 9512.5 using 9518.75 or lower as top strike? It’s now a put fly. The six call strikes from 9487.5 to 9518.75 have 1.65 million of open interest and have all vaulted in-the-money. That’s a lot of fine tuning on a contract that only has 1.1 million open. SFRU4 was up 23 on Friday. The atm straddle settled 25.5 (9525 strike) vs the atm straddle on Wed, July 31 at 11.75 (9493.75 strike).
What to do now? Well, I think prices may be somewhat different from Friday’s settle by the time we walk in Monday. FFF6 sub-3% ? The contract settled 9704, up 32.5 on the day!
I feel as if 3% should be considered a soft cap on reds and greens (Contracts from Sept’25 to June’27). Peak settle on the SOFR curve Friday was SFRM6 at 9699. I would favor patiently working offers in green midcurve call spreads.
In blue midcurves I am a buyer of put spreads. Vol will most likely decline on any sell-off, but the calendars hint at relative weakness in blues (or back end of curve in general). For example, SFRZ7 settled 9690, which was up 18. That compares to SFRZ5 which settled 9693.5, +28.5.
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NOTE: I am not denigrating risk managers. (And to my peer brokers, denigrate means “put down”) Frankly, I’ve always been amazed at how well the CME and the clearing firms respond to rapidly changing conditions. The Fed could use some of these guys. I have to relate one more quick story of ‘old days’ risk management. I worked for a guy who had owned a small clearing firm at the CBOT; he cleared a bunch of grain locals. After crazy days he would stand at the floor entrance and watch his guys coming in the next morning. Anyone with glazed eyes was pulled off for a discussion.
BULLET POINTS FROM FRIDAY
*NFP just 114k. Rate leapt to 4.3%…last time here in late 2021.
*Yields imploded. The 2yr treasury sank 50 bps this week to 3.88%. 5’s fell 45 bps, 10s 40 and 30’s 34. Things are so volatile it’s not even worth being specific; for my purposes I’ll characterize the curve using old fractional conventions: Twos 3 7/8%, Fives 3 5/8%, Tens 3 ¾% and Thirties 4 1/8%.
*SFRU4/U5 down to -158 > 6 twenty-five bp eases
*October FF are now 9513.5. Current EFFR 5.33%. Cut of 25 is 5.08% or 9492. Cut of 50 is 4.83% or 95.17. October is essentially there…after MANY have said Fed should stay on hold thru year-end.
*I titled my July 23, 2024 daily missive: TU (2yr) calls for earthquake insurance. I wrote: “…worth considering buying TUU4 103c which settled 3.5 ref 102-14.
On Friday, TUU4 settled 103-186, and U4 103c settled 41. Even a blind squirrel….
*New low in forward inflation measures, Below is a chart of ten-year breakeven; 204 bps on Friday, just at the upper end of pre-Covid levels.
| 7/26/2024 | 8/2/2024 | chg | ||
| UST 2Y | 438.9 | 388.0 | -50.9 | |
| UST 5Y | 408.0 | 362.5 | -45.5 | |
| UST 10Y | 419.8 | 380.0 | -39.8 | wi 379.5 |
| UST 30Y | 445.5 | 411.2 | -34.3 | wi 410.8 |
| GERM 2Y | 262.2 | 235.2 | -27.0 | |
| GERM 10Y | 240.7 | 217.4 | -23.3 | |
| JPN 20Y | 182.7 | 172.1 | -10.6 | |
| CHINA 10Y | 219.0 | 212.4 | -6.6 | |
| SOFR U4/U5 | -127.5 | -158.0 | -30.5 | |
| SOFR U5/U6 | -30.0 | -13.5 | 16.5 | |
| SOFR U6/U7 | -0.5 | 6.0 | 6.5 | |
| EUR | 108.60 | 109.11 | 0.51 | |
| CRUDE (CLU4) | 77.16 | 73.52 | -3.64 | |
| SPX | 5459.10 | 5346.56 | -112.54 | -2.1% |
| VIX | 16.39 | 23.39 | 7.00 | |
