Introduction
This article provides an overview of using Eurodollar spreads as a low risk instrument to trade economic news and interest rate cycles. We’ll look at two types of spreads: bull spread and bear spreads. We’ll also look at when to place these spreads.
What are Eurodollars?
First of all, let’s clear something up. We are not talking about the currency here. This is not the Euro (EUR/USD). The Eurodollar is an interest rate product based on a 90-day bank deposit. It has become the benchmark for US Dollar based, low risk (but not government guaranteed) bank deposits.
Eurodollars futures are quoted as 100.00 minus the interest rate. A rate of 1.00% would therefore be a price of 99.00. Price and rates therefore have an inverse relationship. As rates fall, prices rise. As rate rise, prices fall. Each basis point (0.01) is worth $25.
The CME launched the Eurodollar contract in 1981 and it has since become the most actively traded futures contract on the globe. Contracts are listed on the March quarterly cycle (Mar, Jun, Sep and Dec)
extending out 10 years. Serial contracts are also offered on the nearest four calendar months (those not part of the March quarterly cycle).
Given deep liquidity across expiries for at least several years out, the contract is popular among spread traders and provides some terrific trading opportunities.
The opportunities come by way of movement in interest rates and more importantly changes in interest rate expectations. For this reason, some may argue the best time to trade Eurodollar spreads is when interest rates are at or near a turning point – e.g. right now. More on this in a moment, but first some theory…
What are Spreads?
The simplest of all spreads involves simultaneously trading in two related futures contracts – a long position in one and a short position in the other. The idea is to profit from a change in the price differential.
More complex spreads involve three, four or even more contracts combined. For now, we’ll just stick with spread using two contracts. Specifically, we’ll look and bull spread and bear spreads in the Eurodollar market.
The main benefits of trading spreads are a significantly lower margin than outright futures and lower volatility. Some spread traders also point to more reliable technical signals, but that is a matter of opinion and experience.
Bull Spreads
To create a bull spread, a trader would buy the nearer to expiry contract and sell short the distant contract. Examples of bull spreads are:
Bear Spreads
There are no points for guessing a bear spread is the opposite of a bull spread. To create a bear spread, a trader would sell short the nearer to expiry contract and go long the distant contract. Examples of bear spreads are:
Bulls, Bears and Roses by Other Names…
For the purists out there, it is true that some Eurodollar traders refer to a bull spread as defined above as a bear spread and a bear spread as defined above as a bull spread. There is a reason for this, but it’s unimportant. What is important is the concept not the name.
Calculating and Charting Spreads
There are two popular ways to quote and display ‘two-legged’ spreads. One is calculating the spread as the buy side minus the sell side. The other is to calculate the spread as near month minus far month. Analysts prefer the former. Brokers prefer the latter.
I prefer to use buy side less sell side as it is just makes more sense on a chart, but for this article, we’ll look at one spread and one spread only to save confusion. Charting the Sep 2010 – Sep 2011 would look like this:
To enter a bull spread, you would buy the Sep 2010 and sell the Sep 2011. In the chart above, you would want that price to then increase. To enter a bear spread, you would sell the 2010 contract and buy the 2011. In the chart above, you would want the price to decrease.
Trading Bull and Bear Spreads
Now, all the definitions are behind us. This is the important part. The key question to answer is “Why bother with spreads?”
The reasons for trading spreads vary from market to market, but for Eurodollars, you are taking a bet on the expected direction of interest rates. Just like the underlying contracts, spreads are driven by economic news, comments from Fed officials, movement in the US Dollar and all those macro events.
The best way to understand how spreads move is with an example. Here is that Sep 2010 – Sep 2011 chart again:
Point 1 shows the impact of Lehman Bros. The weeks that followed the news of the bankruptcy saw Eurodollars rally. The rally in the spread at Point 1 shows the nearer contract rallying more than the deferred contract.
To get a good feel for Eurodollar spreads, you have to think about why. Why did the nearer contract rally further? The Lehman news was negative for the economy. Negative economic news means lower interest rates, hence the rally in Eurodollars overall. At Point 1, the nearer contract rallied further as the market simply assumed the problem would affect the affect the economy more within the nearer term. Kinda seems logical.
Now consider Point 2 where the spread falls. Without looking any deeper, you could easily assume Eurodollar prices corrected what was an overbought move. However, this was not the case. Over this period, Eurodollar price continued to rally not fall (implying lower interest rates).
The chart below shows the rally and pullback in the spread (the candlestick chart) and the rally in the underlying contracts over the same period (the solid blue and orange lines and red arrow).
The reason the spread fell was the distant contract started rallying more than the nearer one. So interest rates overall were still falling (prices rising), but it was the deferred contract that was leading the way. Again, to understand Eurodollar spreads, you have to think about why this was happening.
While there were other news and bailout details coming out at the time, the spread was moving thanks to a change in perception. The idea that this was more a longer term problem was starting to sink into the market. As such this spread fell back given the rally in the Sep 2011 contract.
It’s interesting to note there were two distinct moves in the spread (up and then down) while Eurodollars themselves were going in just one direction. The difference was the changing perception on how long the GFC would affect the economy.
Now to Point 3. At the start of the bull move shown as Point 3, the rally in Eurodollars abated and towards the end of that rally, Eurodollar prices fell.
Again this was driven by perception. It was the perception that the economy would over time begin to show signs of recovery. The low in the spread was in fact at the same time much of the stimulus package details were released. A stimulus package itself could not change the market in the blink of an eye. What changed was the perception of the strength of the economy given those measures.
So from this, we are starting to see how the mood of the market is represented in the Eurodollar spread. It’s interesting isn’t it?
And so to Point 4. This is where we are right now. The spread is currently around that 1.40 level. That is, Sep 2010 Eurodollars are trading at 1.40 points higher in price than the Sep 2011 contract. This means the market is pricing in short term interest rates at 140 basis point higher in Sep 2011 than in Sep 2010.
For an interest rate position trader, the question you have to ask is if this is a fair amount? Has the market undervalued economic prospects? Remember, all current perception is factored into the market. The thing that will change the spread is a change in perception.
If anything, you could argue that spread is a little high. Any more news that would imply a prolonged recession is not going to have as much of a positive impact on the spread as strong economic news will have a negative effect. Does that make sense? All the doom and gloom news has already been through the market and had its impact. The market moving potential is in the recovery.
In other words there appears more risk of a drop in the spread. Stronger economic news will impact the longer dated contract more than the near one and as such see a drop in the spread.
Spreading in Perspective
All of the above can get a little confusing if you haven’t thought about these things before. Those readers that studied economics back in high school will remember being taught a whole series of ‘if A happens, then B will follow’.
For example if the government spends more then things like GDP, interest rates and inflation will increase.
To understand Eurodollar spreads and spot opportunity, you have to do the same. Think ‘if A happens, then the spread will do B’.
Right now interest rates are low and so much bad news is in the market. That one spread we looked at has hardly moved since June. A bad piece of data here and there is not going wake that one up and see it continue higher. However should we see more positive economic figures start to emerge, then that spread has to potential to start a move lower as longer dated contract would fall further than the nearer contract.
Conclusion
The Eurodollar is probably the best futures market in which to trade spreads. High liquidity for contracts several years out means there is a huge range of spreading combinations.
The best opportunities seem to pop up around the time of economic and interest rate uncertainty. Choosing a position is often as much about understanding the market’s mood as it is using technical
