In late January, the T-bond/T-note spread broke out to record highs as the cash yield on the 30-year bond sank to a record low. Both reversed shortly after and signaled a bearish trend change. We could have a tiger by the tail on this trade, so the IMC blog put out a trade strategy (hypothetical, of course!) to add to short positions if/when the spread accelerated to the downside.
The short T-bond/T-note spread is currently held in the March contracts. These have to be rolled over before Friday because of the First Notice Day. Typically, this is a simple procedure. But there’s a twist to the rollover this time. The June T-bond contract is trading at an eye-popping 15-full point premium over the March contract. There is a logical explanation for this: The June 2015 contract is the first futures contract that will reflect the period between 2001 and 2006 when the US government did not issue any 30-year bonds. This puts a premium on the price. The change in the contract specs will be reflected in the September and December contracts as well.
Due to the substantially increased premium on the June 30-year bond contract, the volatility of the June T-bond/T-note spread is noticeably higher and the June T-bond/T-note spread difference is approximately double that of the March T-bond/T-note spread. An equivalent short sale entry to the February 6th trend change signal with a risk to new highs would be approximately four and a half points compared to nearly two points. Therefore, traders should adjust for the difference in volatility by reducing the position size on the June spread to half of the March position size.
Another thing that needs to be changed is the size of the ‘interval ladder’ that we are using to enter/exit the spread. We were using intervals of two and one-quarter points (2-08) to trade the March spread. Since the volatility of the June spread is double, we will now use intervals of four and one-half points (4-16) to trade the June T-bond/T-note spread.
For the short March T-bond/T-note spread at approximately 18-30 (premium T-bonds) on February 6th and the short ‘add-on’ March T-bond/T-note spread at approximately 16-20 (premium T-bonds) on February 20th, roll the short March T-bond contracts and the long March T-note contracts to the June contracts at the market-on-close on Wednesday, February 25th. Be sure to adjust for the difference in volatility by reducing the position size on the June spread to half of the March position size. Once the rollover to the June contracts has been made, risk both the June T-bond/T-note spreads to a two-day close above 36-07. Theoretically, this is the breakeven level for the initial short position. Therefore, you should size your June position so that a close at 36-07 would show a breakeven on the initial position and a loss on the ‘add-on’ June position that carries the same percentage risk size to your account as the ‘add-on’ March position initially did.
In addition, keep hypothetical orders working for two more ‘add-on’ positions in the June T-bond/T-note spread. The next ‘add-on’ will be triggered on a close at 27-27 or lower. The trailing stop will continue to work to liquidate all units on a two-consecutive day close four and one-half points (4-16) above the most recent entry price.