Are Eurodollar Options Relevant Again?

October 14, 2020 08:19 PM
Interest Rates Report

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As the presidential election draws near, U.S. markets have taken on a different tone. Previous speculation about a Democratic win centered on a worse case scenario of taxes and increased regulation. Add to that the fear of President Trump contesting a close race and it didn’t look good for markets.

Now, however, most views see not only a win for Democratic candidate Joe Biden, but a clean sweep of Congress as well. With a widening gap in the polls, the chance for a contested election have faded and the markets have flipped their views. In fact, in a recent report, Jan Hazius, an analyst at Goldman Sachs, stated that a “A blue wave would likely prompt us to upgrade our [U.S. economic growth] forecasts.” He he added that a bluewave, “…could pull forward the first hike by up to 2 years, mainly because of the higher inflation path.” This would certainly be good news for the sleepy short-term interest rate (STIR) markets.

Interest rate markets have been slow

With the Fed holding rates at low levels, most action in Eurodollar options centers around either the front month contract, as traders speculate on Libor and short-term funding issues while trying to pin strikes, or the deferred midcurves, such as the 3-year (blue), 4-year (gold) and 5-year (purple) midcurve contracts.

For those who are new to Eurodollar options, the midcurve contracts trade off the longer dated future, but expire in the near month. For example, the Blue December (E3Z0, EDZ3) contract would trade off the EDZ3 future, but expires on December 11, 2020. Midcurves contracts are a preferred method for traders to express views further out on the Eurodollar curve.

Of course, we’ve seen this before. In 2013, for example, the blue, gold and purple midcurves were very active and often a very profitable trade.

Eurodollar volatility graph
Source QuikStrike

Other than half days around holidays, I can’t recall seeing such low numbers. As it stands, we are on track to have 4 out 5 trading days with about 400K contracts traded or less (Friday’s total stood at about 210K as of this writing). And for 5 days in a row under 1 million Eurodollar options contracts traded. Much of this has to do with where rates are and the Fed pouring cold water on the negative interest rate policy (NIRP) solution, but we must acknowledge the importance of the trading floor. I’m not suggesting that volumes would be exponentially higher if the pit was open, but I highly doubt we’d have 4 days of less than 400K and 5 days of less than 1 million.

This chart shows the volatility difference between the front quarterly contracts and the midcurves. Keep in mind, this was during a year in which the 4 quarterly contracts (EDH13-EDZ13) all settled within 4 basis points of each other.

Deferred midcurves options seeing renewed interest

Most of the recent activity has been focused in the blue midcurves.

Open interest has increased dramatically over the last month, with a particular focus on puts.

Just last week, we saw a buyer of the blue March (E3H1, EDH4) 99.125/99.00 put spread vs selling the 99.75/99.875 call spread, paying 0.25 on 150,000. In fact, there have been a variety of put strategies traded in blue March targeting the 99.00-99.375 strikes.

Although still low by historical standards, we have seen signs of life in the blue midcurve volatility.

ATM Volatilty

Source QuikStrike

What to look for now

Volumes have picked up in Eurodollar options recently. In fact, between Friday, October 2, and Friday, October 9, we had 5 out of 6 trading days with volume over 800,000. This is the most sustained daily volume since Mid-March.

As we move closer to November 3 and the market continues to see a Democratic sweep, keep an eye on theses blue midcurves. As futures move lower, don’t be surprised to see some profitable Blue December (E3Z0, EDZ3) put structures rolled forward, most likely into Blue March. There were a lot of E3Z0 99.625/99.50 put spreads and 99.625/99.375 put spreads bought over the last few months.

Also, look for some strike adjustments in the Blue March four way structure as well, perhaps widening out the put spread or covering short calls cheaply.

No election predictions will be made here, but if the recent turn in market thinking is correct, Eurodollar options could go from dormant to dominate. And we’ll be left looking back at what a gift these futures levels really were!

About the Author

Albert Marquez is a Chicago-based options and futures broker, specializing in interest rates. You can reach Albert on Twitter@STIR_Report or stirreport@gmail.com.