Calculating Profit and Loss in Interest Rate Futures

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 T-bill over another. The Chicago Board of Trade (CBOT) division of the CME Group futures exchange has recognized this; therefore the CBOT exchange offers standardized contracts to represent each of the government issued fixed income securities known as Treasuries. Similarly, the Chicago Mercantile Exchange division of the CME Group, offers futures trading in 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 futures contracts carry 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.

Before we cover the basic specifications of each contract, it is important to be aware of a few facts regarding Treasury 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; it will help you to determine which avenue best suits your risk tolerance and personality.

Interest Rate Futures

Treasury Futures

Several years ago 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 Treasury futures contract for experienced commodity traders to involve themselves with. However, the Federal Reserve’s failure to issue new 30-Year bond contracts on a regular basis has worked against the popularity of the contract. In the meantime, shorter maturities such as the 10-Year 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 T-Bond Futures

Symbol: ZB

The 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 might 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 T-Bond at maturity is $100,000; therefore the contract size of one futures contract with the 30-year Treasury 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. In the case of the 30-year Treasury futures, a rally from 156’0 to 157’0 is equivalent to a price increase of one handle.

The discussion of the relationship between Treasury futures prices and interest rates is to extensive to be included here, but to clarify pricing here is a general explanation of the relationship between the current Treasury price relative to it’s par value. If a futures contract is trading in excess of its par value of 100’0, interest rates have gone down since the issuance of the underlying Treasury securities. If the futures contract is trading below par, interest rates have gone up.

The long bond trades in fractions of a full point; specifically, ticks equivalent to 1/32 of a full point or $31.25 figured by dividing $1,000 by 32. Treasury bond futures are quoted in handles, and fractions of a handle. Further, by the number of full points (worth $1,000) and an incremental fraction of such. Thus a typical bond quote may be 152-24. This is read as 152 handles and 24/32nds. At this quote, the futures contract has a value of $152,750. This is calculated by multiplying 152 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 in Treasury futures. 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 commodity trader goes long a September bond futures contract at 155’22 and is later able to sell the at 156’24 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

156 – 155 = 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 futures contract at 158’12 and buys the contract back at 156’27 may have a difficult time calculating her trading 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 denominator of the sell price, 12, is much smaller than the denominator 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 157 and increase the fraction by 32/32nds. Thus, the new selling price is 157’44. This is a number that can be easily worked with.

44/32 – 27/32 = 17/32, 17 x $31.25 = $531.25

157 – 156 = 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 T-Bond futures traders can calculate their trading results. Obviously, not all bond futures trades or traders will make money.

10-Year Note Futures

Symbol: ZN

The 10-year note futures, or simply “the note”, has many similarities to the 30-year bond futures contract. The contract size and the point value are all common characteristics. Similarly, if you were able to come to peace with the 30-year bond futures 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. Unlike the 30-year bond futures contract, the T-note 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 note futures from 123’29.5 and places a buy stop to protect him from an adverse move at 125’15.0 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 125’15.0. 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 125’15.0 to 124’47 ((125 – 1) + (15/32 + 32/32)).

47/32 – 29.5/32 = 17.5/32, 17.5 x $31.25 = $546.87

124 – 123 = 1, 1 x $1,000 = $1,000

Total Risk = $1,531.25 plus commissions and fees

5-Year Note Futures

The 5-year note futures contract is identical to the T-bond and the 10-year in terms of contract size. Each 5-year note futures 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 32nd is broken into 4 minimum increments. In other words, each 32nd moves in quarter increments or .25/32. If you recall, the 10-year note has a minimum price fluctuation of .5/32, and the 30-year bond has a minimum tick value of 1/32nds. 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 futures 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 119’10.25 and places a limit order to take profits at 117’05.50 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 – 5.5/32 = 4.75/32, 4.75 x $31.25 = $148.43

119 – 117 = 2, 2 x $1,000 = $2,000

Total Profit if Limit Order Filled = $2,148.43

2-Year Note Futures

The 2-year note futures contract 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 32nd, 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 futures contracts is due to fact that the U.S. government issues significantly more debt in the 2-year maturity than any of the others. Accordingly, there are more 2-year 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 Treasury futures, calculating profit and loss in the 2-year note must be slightly adjusted. A trader that is long a September 2 year note futures at 109’11.75 and is later stopped out of the trade at 108’02.25 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

109 – 108 = 2, 1 x $2,000 = $2,000

Total Loss = $2,593.75

Eurodollar Futures

Many 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 off-shore 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 and based on daily trading volume, Eurodollars are considered the most liquid futures market in the world.

The contract size of a Eurodollar futures contract is $1,000,000, and similar to the other interest rate futures products, contract expirations are quarterly; March, June, September, December.

Eurodollar futures 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 fundamentals and technical analysis to construct a bearish strategy.

The point (handle) value of a Eurodollar is $2,500 and the tick value is $25; so a drop from 99.50 to 98.50 equates to a profit or loss of $2,500 per contract. The Eurodollar futures 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 futures 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.

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 99.085 (99.08 ½) and later sells it at 99.290, 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).

9929 – 9908.5 = 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.

Consumer Confidence at 125...are you kidding me?

The Conference Board's Consumer Confidence index for the month of March was reported on Tuesday to be 125.6! If I recall, this index bottomed out near 20 as the stock market was making what we now know as a generational low in 2009. I started to type that the March reading was the highest I've ever seen, before noticing that it printed a 128.6 at the end of 2000. In all fairness, I was a clueless college student in 2000 so even if it happened, I probably didn't actually see it.

The premise behind this index is that consumers are feeling emboldened by a positive view of business, labor market conditions, and the overall economy. On a side note, the survey responsible for this index was taken before the failure of the health care reform bill. Nevertheless, it is clear that consumers are feeling good and as a result, they are putting money to work in the stock market.

If you look at a long-term chart of the Consumer Confidence index, it almost identically coincides with the direction of the stock market. With this in mind, there could be some red flags waving. In the past, we've seen major tops and bottoms in the stock market at times in which the Consumer Confidence index is at extreme highs and lows, respectively. Particularly readings in excess of 100.

For instance, the last time the Consumer Confidence was this high in 2000, the S&P peaked dropping 50% over the next two years. Likewise, the Consumer Confidence was near 110 in 2007 just before the S&P fell 60% in the subsequent two years. Since the election, we've seen the Consumer Confidence index breach and hold above 100 for the first time since 2007 (and prior to that the early 2000s). Will this time be different?

*It is only fair to note that the Consumer Confidence hovered above 100 in the mid-2000s for quite some time before the stock market rolled over and during that time stocks rallied nicely (until they didn't).

A healthy jobs report, a potential Dodd-Frank peel back, and renewed talks of tax cuts propelled markets higher.

Financial futures traders loved Friday's events and they expressed that sentiment by buying into US assets. For the first time in a LONG time, the jobs report was judged by its merit as opposed to the anticipated reaction by the Federal Reserve. In other words, the markets no longer seem to be held hostage by the Fed's every move. Instead, investors are looking to speculative economic growth as the driving factor with the Fed's monetary policy as a secondary concern.

Non-farm payrolls grew by 227,000 in January but the good news was slightly dampened by sluggish wage growth. On a positive note, the unemployment rate ticked higher to 4.8%. No, that isn't a typo...a higher unemployment rate is a positive. The increase in the unemployment rate is a sign that the labor force has increased. In short, some of those who were discouraged from looking for work have found a reason to get back on the job-hunt (remember, the headline unemployment report fails to recognize those who stopped looking for a job out of frustration but are still unemployed).

As most futures traders expected, the Federal Reserve didn't take action

Going into today's FOMC meeting conclusion, the Fed Funds futures markets were assigning a 15% probability of a rate hike. As it turns out, the majority of traders were correct in assuming the Fed would bypass the September meeting. In our view, we probably won't see any action until December but of course, the November meeting is still up in the air.

We recently took part in a survey conducted by FXStreet.com in which we found the results to be rather interesting. According to the survey, expectations of the rate hike campaign are rather meager. The consensus average of those polled is calling for the rate hike cycle to stop at about 1.5%. Some were even predicting the Fed would stop at .75% (only one more rate hike from the current level). Also interesting, almost 60% of those polled believe quantitative easing is a tool the Fed will continue to use in the mid-to-long term.

If you are interested in seeing the details of the survey, click here: (http://www.fxstreet.com/analysis/fxsurvey-dovish-fed-to-hike-interest-rates-in-december-qe-might-return-in-the-mid-term-201609201150)

The Fed is as hawkish as they've been in years...

A hotter than expected inflation reading and more confirmation from the Fed that they will be seeking at least three rate hikes this year set a negative tone for Treasuries. However, the same news was seen by stock trader as a sign of economic growth and prosperity. Accordingly, the seemingly never-ending stock market rally logged another session of buying. What can we say? This is a bull market...and nothing can derail it. In recent weeks we've seen chaos in Washington, riots in the streets of our cities, a North Korean missile headed for our shores, but we've yet to see investors interested in taking profits in the equity markets.

If you ask me, the bulls are starting to get greedy (that said, we've obviously been wrong about the strength of this rally). According to our friends at Consensus, their bullish sentiment index has reached 76%. Generally speaking, this signifies an extreme that often results in a reversal. Likewise, The AAII Index suggests only 25% of those polled were bearish the market. The bus could be getting full...and we all know that that means.

This week's news docket is skimpy but be cautious of the Fed's Beige Book on Wednesday afternoon.

I'm sure there will be plenty of headlines coming out of DC, as usual, but scheduled economic news is thin. This should leave traders focused on earnings, which are projected to be relatively positive. As mentioned in the previous newsletter, when earnings season arrives during a market dip it tends to be supportive. We suspect this time will conform to the norm, leading the S&P 500 futures higher for the next couple of weeks.

With that said, don't underestimate the potential market reaction to Wednesday's Fed Beige Book. With the Fed's interest rate hike campaign in full force, the markets will be interested in knowing their thoughts on the domestic economy.

Also, the early April stock market dip could have been tax related selling (investors liquefying to pay tax bills). However, post-tax deadline we could see funds flow back into the market equity.

Inflation in check and economic data steady

Yesterday we learned that October retail sales ticked to .8% beating expectations of .6%. We saw similarly positive news from the Empire Manufacturing index which was a positive 1.5 for the month of November despite a negative reading of 6.8 in the previous month. This morning, the government released the latest Producer Price Index (PPI) suggesting that inflation was stagnant. We'll get a clearer picture tomorrow morning with the CPI (Consumer Price Index) report, but if it is similarly benign we expect Treasuries to move higher on the news.

From yesterday's newsletter just in case you missed it:

Although it isn't grabbing headlines like the Treasury market is, the US dollar index likely holds the key to our financial future. If you recall, a stronger dollar puts pressure on commodity prices such as gold, crude oil and even the grains. We are also seeing money from overseas investors rotate into the greenback in search of yield and equity market performance. However, if the dollar continues higher, there could be trouble ahead for domestic asset prices.

For instance, if the dollar index breaks above 101.50 it would likely result in a breakdown in commodities (below support levels which have been in place for months, and in some cases years). Similarly, Treasuries could continue to plunge. After all, if foreign investors are paying "top dollar" to exchange their currency to purchase securities, current Treasury yields won't be worth their while. They'll be looking to the equity market for gains.

Energy stocks have likely been holding the market up.

Crude oil, and now natural gas, have made impressive moves higher. As a result, energy companies making up a significant amount of market capitalization and playing a big role in the US economy has been positive.  Nevertheless, if crude oil prices come back to reality ($50s?), that will work against stocks. 

In our view, the oil market is an accident waiting to happen.  A few weeks ago we wrote a piece suggesting the intermediate-term top in oil would likely be somewhere in the mid-to-low-$70s and we still feel that way. Speculators are overly long, seasonals are starting to turn bearish, and the market has probably over-priced supply concern risk premium. Lower oil will likely translate into a lower S&P 500.   

We aren't ultra-bears in the stock market but we do think the easy money on the upside has been made.  The market looks and feels tired, the weekend trade news celebration was short-lived, and we are seeing trading volume disappear as we head into the summer doldrums.