Tuesday, February 20, 2007

Translating an outlook into a trade

Todd recently asked me the following question in a comment:

How far out are you looking when you make such statements ? And how do your longer term views (1-2 years out) effect your short term trading ?

Great question. I have two core tenets of investing that relate to this.

  • There are too many variables for any economic forecast to be particularly accurate.
  • Make your bets where you have the best visibility.

To explain, let me use my 10-year forecast as an example. In my 2007 Forecast piece, I predicted a 4.90% 10-year rate by year-end, which I still like. However, when the 10-year was in the upper 4.70% range, I've wrote that I was short-term bullish on bonds. How do you take both ideas and turn it into a trade?

Here is how I thought through my portfolio position at the time. In late January, the bond market looked like it was trading on a buyer's strike. By this I mean, the market looked like long-term buyers were staying out of the market, leaving short-term traders as the only force pushing prices around. You can see my brief case for the buyer's strike here.

When my views are at odds, I ask myself, where is the better visibility? In this case, I look at my buyers strike theory, and felt very confident that the risk/reward was in favor of a small rally. On the other hand, while I still like 4.90% as the eventual level on the 10-year, we were already within 10bps of that number on Jan 31. Not much upside there. Plus, 4.90% is an approximate figure. I view 4.81% as within the margin of error.

So I added duration. So far it has worked out alright, as we're down to 4.67% on the 10-year today.

Another way to play this is to find a play which will work in both cases. For example, I think rates are near their peak at 4.81% on Jan 31. But I think any rally will falter around 4.50%. That kind of low-vol environment calls for a play in MBS. Essentially buying MBS is like shorting options, you can make money on the vega. Put another way, the risk of owning MBS is that rates will fall substantially and your principal will be returned in a lower rate environment. Alternatively, if rates rise your principal will return more slowly, preventing reinvestment at higher rates. If nothing happens with rates though, then you are being paid to take a risk that never materializes.

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