The Tycoon Report

Here's a Futures Contract Especially for Contrarians

Sunday, May 10, 2009 | Barbara Cohen

Ever met someone who was a complete "Contrarian"?   Wikipedia defines a contrarian as "one who attempts to profit by investing in a manner that differs from the conventional wisdom." 

Most individual investors generally like to trade long.  Contrarians seem to like to short ... just to be contrarian.  For those Tycooners who love to turn the world on its heels, trading futures contracts might be for you ... and there's one in particular that might pique your interest and, potentially, your profits.

Today's article discusses a futures contract group that I personally love to trade ... perhaps because I am a true contrarian.  When others are bailing out of a position, I am known to enter.  We're talking about trading the Interest Rate Products. Specifically, I want to look at the 10-year Note (ZN), and the 30-year Bond (ZB). 

My preference is the ZN because the liquidity is so much higher.  In recent trading activity, the ZN averages 500,000 contracts changing hands daily, compared to the ZB, which only weighs in with 150,000.

Both the ZN and the ZB originally came from the CBOT, the Chicago Board of Trade.  Unfortunately, the Chicago Mercantile Exchange (CME) had to get its paws on the CBOT, and now you can only trade the Treasury Interest Rates at the CME.  The ZB used to be the hotter of the two, because one tick gave you $31.25.  But leave it to the CME, as it halved the tick size in March 2008 back to the same as the ZN, at $15.625.

The $15.625 represents one-half of one thiry-second (1/32) of one point.  If you have a real-time trading platform, you will see that the ZN and ZB increments are 1/32. 

Why is Trading Treasury Futures Contrarian?

There are two types of Treasury futures traders -- those who buy and hold Treasury futures to hedge their existing bond funds, and the daytraders (or speculators) who go in for the quick buck.  If you have read any of my earlier articles, by now you know I am not a buy-and-hold kind of trader.  But for educational purposes, let's look at both types of trades.

First, the buy-and-hold Treasury trader.  Why would someone want to buy and hold a bond futures contract? 

Let's say that you managed a large portfolio of 30-year bonds. For many hedge funds and mutual funds, until recently, 30-year bonds were the only positions they were willing to hold.  Traditionally, these funds use Treasury bonds as a flight from equities. So, when the stock market is nosediving, hedge/mutual funds buy bonds and sell stocks.

Now, say that the Treasury bonds are realizing a 3% annual interest rate (at a time when CDs are giving 1%-2%).  Three percent is not great, but certainly better than 1%-2%.  Fund managers may consider taking a position in Treasury bond futures as a hedge, just in case the interest rates decline and the bonds are sold off at a loss. 

You'll have to think with this for a moment about this. It's a bit tricky.

When stocks go up in value, hedge funds and mutual funds buy stocks and sell Treasury bonds.  When stocks are plunging, fear drives the funds away from stocks and toward buying Treasuries because Treasuries are considered a safe place to park money while waiting out the bad news.

Now, add the fact that bonds pay interest.  When interest rates are high (and 3% is generally considered high), and the interest from CDs is low, hedge/mutual fund managers who are still on the fence about buying stocks, buy bonds instead.  Our international buddies, the Chinese and Japanese, can't wait to buy more bonds when the interest rates go up. 

But, when interest rates go down, bonds are like poison -- that is, investors can't get rid of them fast enough.  In the same way, when the stock market is soaring, hedge/mutual fund managers may sell a portion of their bonds and buy stocks again.

For hedge/mutual fund managers, they weigh the potential profit from stocks' dividends against bond appreciation and interest rates.  Since the recession, many stocks have at least halved the dividends they were paying.  So now, hedge/mutual fund managers only weigh the stocks' appreciation against a 3% interest rate and bond appreciation. 

That's why so much big money is still on the sidelines as we speak.

Hedge/mutual fund managers, especially those that are fully vested in bonds, need to hedge their positions -- thereby managing their portfolio risk. They are kind of looking to buy an insurance policy to mitigate the chance of wild price fluctuations.  

This is where Treasury bond futures come into play. Remember, a futures contract is an agreement to buy or sell a specific amount of a financial instrument at a particular price on a stipulated future date.

Fund Managers Look to Hedge Their Positions

Using bond futures, hedge/mutual fund managers can preserve the investment value of their portfolios by SELLING (i.e., shorting) Treasury bond futures, thus locking in their sale price today, in case their bond fund loses value.  When the value of 30-year bonds goes up, the value of the 30-year bond futures contract, ZB, also goes up.

Conversely, hedge/mutual fund managers who are planning to buy Treasury bonds for their portfolios in the future may want to BUY Treasury bond futures contracts today. Why? Because the managers can lock in a maximum purchase price they'll have pay for the bonds. 

Suppose a fund manager won't have capital available to buy 30-year bonds for three months.  In three months, the value of the bonds he wanted to buy might have skyrocketed.  So, for a far-smaller amount, he can buy bond futures contracts at today's market price that guarantees him the right to buy a specific amount of Treasury bonds at a specific later date at the price he locks in today.

How Can an Individual Trader Benefit?

We can see how buying/shorting bond futures works for hedge/mutual fund managers.

But, you say, "I am just an individual trader.  I don't have a huge portfolio that I need to protect."

Earlier, I told you that there were two kinds of traders: hedgers and speculators.  And I told you that I am not a hedger who buys and holds; I am strictly a daytrader. 

Here's where a contrarian trader does well. 

Generally speaking -- and there are rare occasions when this is not the case -- when the stock market is doing well and soaring, we'll be shorting the ZN and the ZB.  When the stock market is plunging, that's the time to prepare to go long. 

Once in a while, and this is rare, stocks and bonds both go long or both short.  In those cases, I usually don't trade.  It often means that something is up, and I don't want to take any chances.  I wait until I see the "normal contrarian" activity -- that is, one up and one down.

So, if you are a trader who likes being a contrarian, then when the stock market is up, short bonds.  When the stock market is down, go long. 

Or, maybe you are a trader who does not like to short.  On days when the stock market is raising the price of the S&P 500 E-mini futures contracts, go long.  On days when the stock market is plunging, go long with Treasury bonds (ZN or ZB).

Speaking of the Stock Market ...

We now know that banks have to raise $75 billion.  I was listening to a pundit on CNBC tell us to, during the next two weeks, watch for the Dow Industrials to endure a 10% correction.  His viewpoint was that the stress-test hype is over and the banks were feeding off of that to raise their stock prices so they could pay for the billions they have to raise.

We now know that 539,000 jobs were lost in the month of April, with another 70,000 revised lower in March.  And we also now know that the unemployment number has ticked up to 8.9%. Anyway, that is the number they are willing to 'fess up to.  (I think we all know the unemployment number is far higher than that.)

So, after last week -- with unemployment and stress tests behind us -- this week will be a much lighter news week.  We will see the Consumer Price Index and Producer Price Index figures, as well as retail sales.

Last week, retail establishments reported same-store sales. Wal-Mart (WMT) reported well, up 5%, but most of the other stores were still well in the red, with  Macy's (M) down 9%, Dillard's (DDS) down 8%, BJ's Wholesale (BJ) down 5%, Costco (COST) down 7%, Limited Brands (LTD) down 6%, J.C. Penney (JCP) down 7%, Kohl's (KOH) down 6%, Nordstrom (JWN) down 11% and poor Saks 5th Avenue (SKS) down 32%. (The New York rich folks are still not buying.)

At least Target (TGT) reported a minor profit, up 0.3% (anyway, it wasn't negative).  That earned them a small upgrade.  But because Wal-Mart reported well, the retail sales report will tick up. So, on Wednesday, chances are you'll be trading long.

On Friday we'll be watching the 9 a.m. Eastern news release, as the Treasury's net Long-term Treasury International Capital (TIC) flows report is released.

We'll want to compare the data to last month's TIC report to get an idea of just how the international community looks at the U.S. economy.  Remember, this report releases data from two months back, reflecting February's income -- not March when the rally began.






Barbara Cohen
Contributing Editor
The Tycoon Report