Getting Started in Interest Rate Futures 
Written by Carley Garner 
Wednesday, 09 July 2008 13:41 
As you have likely discovered, the term commodity can be used to describe a wide array of assets. The formal definition of a commodity is a physical substance or asset that is “interchangeable” in trade. From a more general standpoint, a commodity is any product that trades on a futures exchange. Along with grains such as corn and wheat, commodities also come in the form of financial assets such as interest rate products and currencies. Just as you wouldn’t prefer one bar of gold over another, you likely wouldn’t have a preference between one Tbill over another. The Chicago Board of Trade (CBOT) futures exchanges have standardized contracts to represent each of the government issued fixed income securities known as Treasuries and the Chicago Mercantile lists a short term interest rate product known as a Eurodollar.
There are several widely traded contracts in the realm of interest rate futures trading. Each of these contracts carries slightly differing market characteristics and in some cases contract sizes, point values, etc. For those unfamiliar with the futures markets, these discrepancies can be overwhelming. However, I hope to deliver the pertinent information clearly in order to make your journey into financial futures trading as pleasant as possible. Trading Interest Rate Futures
Before we cover the basic specifications of each contract, it is important to be aware of a few facts regarding bond valuation. First, longer maturities will react quicker and more violently to changes in interest rates than shorter maturities. Additionally, the value of a bond (the price in which it is trading) is inversely correlated with interest rates or yields. Accordingly, if interest rates go up bond price will drop and vice versa. Keep these points in mind as you review the details of each contract as it will help you to determine which avenue best suits your risk tolerance and personality. Several years ago, the long bond or the 30 year Treasury bond was the primary interest rate product traded on the Chicago Board of Trade (CBOT). During its prime, it was considered the only contract for experienced traders to involve themselves with. However, the Federal Reserve’s failure to issue new 30Year bond contracts on a regular basis has worked against the popularity of the contract. In the meantime, shorter maturities such as the 10Year note benefited in terms of volume and open interest. Similar to the other financial futures contracts, all interest rate products are on a quarterly cycle. This means that there are four differing expiration months based on a calendar year. Thos months are; March, June, September and December. 30 Year TBondThe 30 year bond is often referred to as the long bond due to its lengthy maturity and its spot on the infamous yield curve. You may also know it simply as “the bond” as other Treasury issues are known as Notes or Bills (to be discussed later). The face value of a TBond at maturity is $100,000; therefore the contract size of one futures contract with the bond as an underlier is also $100,000. Knowing this, it is easy to see that a contract can be looked at as 1,000 points, or trading handles, worth $1,000 a piece. What is unlikely to be obvious is that each full point or handle can then be looked at as a fraction. In trading, the term handle is used to describe the stem of a quote. This usage began in reference to currency futures to describe a penny move. For example, if the Euro rallies from 131.00 to 132.00, some may say that it has moved a handle. The long bond trades in ticks equivalent to 1/32 of a full point or $31.25 figured by dividing $1,000 by 32. Adding to the confusion, in early 2008 the CBOT decided to alter the contract by allowing traders to buy or sell bond futures in half ticks or $15.625 but by the fall of 2009 had reverted back to the original minimum tick of 1/32. In other words, a minimum price movement in the 30 year bond is now 1/32. As a trader, it isn’t your job to analyze why or how the exchange determines contract specifications you must simply be aware and accept them. Bonds are quoted by their $1000 handles; thus a typical bond quote may be 10224. This is read as 102 handles and 24/32nds and is equivalent to a contract value of $102,750. This is calculated by multiplying 102 by $1000 and 24 by the tick value of $31.25.
If you are comfortable with the idea of adding and subtracting fractions you will be able to easily calculate profit, loss and risk. For those that are “fractionally” challenged, you may want to trade Eurodollars which are valued in decimals and will be discussed subsequently. However, I am confident that everyone will quickly become proficient bond futures calculations after looking at the examples below. Reading the contract size and point value likely isn’t going to help you to remember or even understand bond futures pricing but looking at a few examples should add some clarity to the details. If a trader goes long a September bond futures contract at 115’22 and is later able to sell the at 116’24 would be profitable by 1’02 or 1 2/32. In dollar terms this is equivalent to $1,062.50 ((1 x $1,000) + (2 x $31.25)). The multiplication is relatively standard but people tend to be unjustifiably intimidated by fractions. If you recall the concept of borrowing, you will be fine. In the example above, it wasn’t necessary to borrow. You could have simply subtracted the numerator (top number in fraction) of the buy price from the numerator of the sell price and multiplied the result by $31.25. Likewise, you would have subtracted the handle of the buy price from the handle of the sell price and multiplied the result by $1,000. 24/32 – 22/32 = 2/32, 2 x $31.25 = $62.50 116 – 115 = 1 x $1,000 = $1,000 Total Gain = $1,000 + $62.50 = $1,062.50 minus commissions and fees The math isn’t always this convenient. There will be times in which you will need to borrow from the handle to bring the fraction to a level in which you can properly figure the profit or loss. For example, a trader that sells a September bond at 118’12 and buys the contract back at 116’27 may have a difficult time calculating her profit. In this case it is easy to see that the trade was profitable. We know this because the handle at the time of the sell was 118 and the buy was 116 but unless you have been doing this for a while it will take a little work to derive the exact figure. The numerator of the sell price, 12, is much smaller than the numerator of the buy price, 27. Therefore we know that we must borrow from the handle to properly net the fractions. In this example, we could reduce the selling price handle to 117 and increase the fraction by 32/32nds. Thus, the new selling price is 117’44. This is a number that can be easily worked with. 44/32 – 27/32 = 17/32, 17 x $31.25 = $531.25 117 – 116 = 1 x $1,000 = $1,000 Total Profit = $1,531.25 minus commissions and fees The purpose of these examples is to give you an idea of how TBond traders can calculate their trading results. Obviously, not all bond trades or traders will make money. 10 Year NoteThe 10 year, or simply “the note”, has many similarities to the long bond. The contract size, the point value and the ability to trade in half ticks are all common characteristics. Similarly, if you were able to come to peace with the 30 year bond calculations the 10 year note won’t be an issue. To reiterate, the contract size of the note is $100,000 which is split into 1,000 handles equivalent to $1,000 and a tick value of 1/32nds or $31.25. The Tnote also trades in half ticks (.5/32) valued at $15.625. Calculating profit, loss and risk in the 10 year note is identical to that of the 30 year bond. To demonstrate, if a trader goes short the 10 year from 113’29.5 and places a buy stop to protect him from an adverse move at 115’15.0 the risk on the trade would be 1’17.5 or 1,546.87. This is calculated by subtracting the entrance price of the short from the potential fill price of the buy stop at 115’15.0. Once again, the math requires borrowing from the handle in order to properly subtract the fractions. This is done by adjusting the stop price from 115’15.0 to 114’47 ((115 – 1) + (15/32 + 32/32)). 47/32 – 29.5/32 = 17.5/32, 17.5 x $31.25 = $546.87 114 – 113 = 1, 1 x $1,000 = $1,000 Total Risk = $1,546.87plus commissions and fees 5 Year NoteThe 5 year note is identical to the bond and the 10 year in terms of contract size. Each 5 year note contract represents a face value of $100,000 of the underlying security. Once again, the contract is comprised of handles valued at $1,000 and each handle is divided into 32nds. However, in the case of the 5 year note each 32^{nd }is broken into 4 minimum increments. In other words, each 32nd moves in quarter increments or .25/32. If you recall, the bond and the note have a minimum price fluctuation of .5/32. If 1/32 is equal to $31.25 and .5.32 is worth $15.625 then we know that .25/32 must be $7.8125. Nobody said this would be easy. The futures markets can be potentially lucrative but there is no such thing as “easy money”. There aren’t any surprises when it comes to 5 year note calculations, other than the fact that they trade in quarter ticks. However, this only requires an additional digit to be typed into your calculator as the process remains the same. A trader that goes short a 5 year note futures from 111’10.25 and places a limit order to take profits at 109’05.50 will be profitable by 2’04.75 or $2,148.43. This is figured by subtracting the limit order price from the original sell price. 10.25/32 – 4.75/32 = 4.75/32, 4.75 x $31.25 = $148.43 111 – 109 = 2, 2 x $1,000 = $2,000 Total Profit if Limit Order Filled = $2,148.43 2 Year NoteThe 2 year note is the “oddball” of the Treasury complex. Unlike the others, this contract has a face value at maturity of $200,000. Thus, the value of a point (handle) is $2,000 and 1/32 is equivalent to $62.50. Like the 5 year note, the minimum tick is a quarter of a 32^{nd}, or simply .25/32. In dollar terms this is $15.625. The difference in the face value of the 2 year note relative to the other Treasury contract is due to fact that the U.S. government issues significantly more debit in the 2year maturity than any of the others. Accordingly there are more 2year Treasury notes traded in the underlying cash market. In other words, the CBOT opted to list the contract with a $200,000 maturity face value to provide “economies of scale” for market participants. This translates into saving the hassle of paying an additional commission which is interesting and noble logic for an organization that survives on trading volume. Due to diversity in contract size and point value relative to the other Treasuries, calculating profit and loss in the 2year note must be slightly adjusted. A trader that is long a September 2 year note futures at 102’11.75 and is later stopped out of the trade at 101’02.25 would have realized a loss of 1’9.5/32 or $2,593.75 (remember, 1/32 = $62.50). 11.75/32 – 2.25/32 = 9.5/32, 9.5 x $62.50 = 593.75 102 – 101 = 2, 1 x $2,000 = $2,000 Total Loss = $2,593.75
EurodollarsMany traders confuse Eurodollars with the Forex currency pair Euro/Dollar. They may sound the same, but that is where the similarities end. A Eurodollar futures contract is written on a 3 month interest vehicle denominated in U.S. dollars but deposited in offshore banks. In its simplest form it is a Certificate of Deposit located in a foreign bank. Accordingly, the interest rates offered to Eurodollar holders (in the cash market) are relatively low due to the perceived risk of default being minimal. Together, the CME Eurodollar futures and options and lead the worldwide industry in open interest with over 40 million contracts held. The daily volume averages 3 million, making this the most liquid futures market in the world. A large majority of Eurodollar volume is executed electronically though the CME Globex platform allowing efficient and timely fills. The contract size of a Euro dollar futures contract is $1,000,000, and similar to the other interest rate products contract expirations are quarterly; March, June, September, December. The point (handle) value of a Eurodollar is $2,500 and the tick value is $25. This contract has a minimum price movement of a half of a tick, or $12.50 for most months but is a quarter of a tick, $6.25 for the nearest expiring month. This is likely because the near month Eurodollar futures contract doesn’t typically see much in the way of price change. The daily price change in the front month is typically less than 5 ticks, making it a great place for beginning speculators to get their feet wet. However, considered yourself warned, the deferred Eurodollar contracts will react more violently to changes in interest rates or climate. If your risk tolerance is low to moderate, stay with the near month. Eurodollars are quoted in handles and decimals and are simply an inverse of the corresponding yield. For example, a Eurodollar price of 97.50 implies a yield of 2.5%. This is figured by subtracting the contract price from 100 (100 – 97.50). Clearly, yields can’t go to zero, so we can infer that the Eurodollar will never trade at 100.00. Thus, as the futures price approaches 100.00, you should consider market technicals and fundamentals and perhaps construct a bearish strategy. Calculating the profit, loss and risk of any given Eurodollar position is different that that of the Treasury complex but is also less cumbersome. Before you begin your calculation, you can simply move the decimal point and multiply each (full) tick by $25. For instance, if a trader buys a December Eurodollar futures contract at 97.085 (97.08 ½) and later sells it at 97.290, the realized profit on the trade would have been 20.5 ticks or $512.50. The mechanics are the same as the other contracts; it is just the point value that differs (but don’t forget to move the decimal two places to the right). 9729 – 9708.5 = 20.5 20.5 x $25 = $512.50 The information included in this article certainly won’t make or break you as a trader, but without familiarity of the basic specifications of the contract that you are trading you aren’t giving yourself a fair shake. After all, awareness and experience may prevent you from becoming emotional or panicky while your hard earned dollars are on the line. ***There is substantial risk in trading options and futures. It is not suitable for everyone.
Carley Garner 1866790TRADE Carley is the author of "A Trader's First Book on Commodities" and “Commodity Options” published by FT Press, a division of Prentice Hall. She is also a broker at http://www.DeCarleyTrading.com. Her enewsletters, The Stock Index Report and the Bond Bulletin, are widely distributed by DeCarley Trading and have garnered a loyal following; she is also proactive in providing free trading education. 
Last Updated on Monday, 01 November 2010 13:44 

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