Short 1000 98 EDM0 puts - Fed will not Hike

Financial Markets – Week of August 10th to August 16th 2009.
Last two weeks economic indicators telling the health of the economy have caused upward and downward revisions to GDP. Initial estimates of manufacturing activity have guided GDP estimates to as high as 4.5%. Consequently treasuries have sold off, equity markets have rised all over the week. Later this week retails sales painted grim picture about consumer spending. This caused GDP estimates to be revised back to lower 3.7%. This contributed to treasury rally and sell off in equity markets.
From this background, looking at Euro dollar futures and treasury futures for opportunities with the lens of market pricing of Fed hikes, treasury supply of debt I believe selling ED futures put options and buying treasury call options are two interesting trades.
Fed came out with it FOMC statement on Wednesday stating economy is showing signs of improvement, inflation is still low and it will keep interest rates low for an extended period at current levels. This means there will be no hikes in interest rates till second half of 2010 until this view gets revised due to incoming information. One important element is unemployment condition in the economy. This is a lagging indicator and there are more signs of worsening rather than improving. This will also force the Fed to not press the interest rate hike button.
Looking at ED strip, I see there is a gap of 40bps between EDH0 and EDM0. This means market is pricing some possibility of 25bps hike in the interest rates. But Fed is indicating otherwise. This makes a case for selling puts. So I would recommend selling puts EDM0. After deciding the contract, next element in the process is to determine the strike level of the option. Strike level of the option is based on the probability of the option attaining the level of by the time of expiry. After looking at probability chart 98 strike level is selected. Benefits of this OTM put are, this option is priced at 0.23 ticks. This means, breakeven level is at 2.23. In other words libor needs to be set atleast above this level for this option to get expired ITM. Time decay works in our favor. Cost of doing 1000 puts is 575,000. Margin requirements for this trade are approximately 600K. Although this trade ties up sufficient margin it is a good trade from the perspective of market pricing the hike, time decay and roll down perspective.
Risks to this trade are
1) Economic recovery takes at a faster pace
2) Unemployment picture brightens
3) Commodity prices rises and fear of inflation takes on hold.
4) Housing stabilizes.
Odd are that none of these scenarios are plausible.












Date
Time (ET)
Statistic
For
Actual
Briefing Forecast
Market Expects
Prior
Revised From
Aug 17
8:30 AM
Empire Manufacturing
Aug
-
5.00
2.20
-0.55
-
Aug 17
9:00 AM
Net Long-Term TIC Flows
Jun
-
NA
$17.5B
-$19.8B
-
Aug 18
8:30 AM
Building Permits
Jul
-
565K
576K
570K
-
Aug 18
8:30 AM
Core PPI
Jul
-
0.1%
0.1%
0.5%
-
Aug 18
8:30 AM
Housing Starts
Jul
-
580K
598K
582K
-
Aug 18
8:30 AM
PPI
Jul
-
-0.2%
-0.2%
1.8%
-
Aug 19
10:30 AM
Crude Inventories
08/14
-
NA
NA
+2.52M
-
Aug 20
8:30 AM
Initial Claims
08/15
-
550K
553K
558K
-
Aug 20
10:00 AM
Leading Indicators
Jul
-
0.6%
0.6%
0.7%
-
Aug 20
10:00 AM
Philadelphia Fed
Aug
-
1.0
-2.0
-7.5
-
Aug 21
10:00 AM
Existing Home Sales
Jul
-
5.10M
5.00M
4.89M
-