Today I´m going to focus on the trading piece. I will explain the Fed Funds, the futures characteristics, the different trading strategies that you can use. If you are experienced in trading, you can jump to the third section.
What is the Fed Funds Rate definition?
The interest rate at which a depository institution lends funds to another depository institution overnight. These funds are maintained at the Federal Reserve. As soon as the federal fund rate rises, borrowing becomes more expensive. You can consider these rates as the base rate that determines the price and the structure of the interest rate curve.
What are the characteristics of the Fed funds futures?
The futures contract has a face value of $5000000 for one month. This means that every time that you take a 1 lot position, you need to deposit $400 (this is an example) margin but it’s like you were trading $5M. The price quotation is 100 minus the average daily fed funds overnight rate for the delivery month.
Example: Fed Funds overnight rate = 3.25, so the Fed Fund futures will be 100– 3.25=96.75
They have a monthly expiration. The tick value depends on the month we are looking at. If it's the nearest expiring month contract the tick value is $10.4175 because it´s quoted in ¼ of the interest rate basis point. The rest of the contracts are quoted in ½ of the interest rate basis point, so the tick value is $20.83 There are 36 months listed at the exchange.
This is the link to the contract specifications on CME:
http://www.cmegroup.com/trading/interest-rates/stir/30-day-federal-fund_contract_specifications.html
You can check the margins as well. Please be aware that they can be different from the ones that your brokerage offers.
Why should we trade them?
They are stable and they don't have big daily changes, there is a lot of liquidity. You should be careful because there are important days in which they can move a lot If you don´t feel comfortable it´s better to be out of the market in FOMC meetings, and economic releases such as GDP, Unemployment rate, CPI, Industrial Production and Retail Sales.
How to trade the Fed Funds futures?
You can trade them based on economic fundamentals, technical analysis, and quantitative models. Let me start on economic fundamentals, if you see the macroeconomic fundamentals are improving, you can think that the Fed funds rate will rise so you need to sell the futures (remember the quotation, 100 minus the average daily fed funds overnight rate). If you think that the economy will deteriorate, you should buy the futures. Please do not follow these simple steps because you should consider more things before you decide to trade.
If you prefer to base your decision on technical analysis you know that you should look for trends, important levels (such as resistances and supports), the market profile provides these levels with the volume traded on them.
As you can see, it moves as the 3 month Eurodollar futures. It closed higher last week due to the FOMC meeting, lower than expected US CPI and US retail sales.
Source: TradingView, Fed Funds Dec18 Futures, daily
This is the Dec18 contract. It’s more directional and the range is bigger than the Dec17. One of the differences between both contracts is that Dec 18 broke the support in 98.39 while the Dec 17 couldn´t even test the support made in July. This means that the traders expect more interest rate hikes in the following year.
Alternative strategies
If you don’t like to take excessive risk with the outrights you can do spreads or combination of spreads such as butterflies or condors. Let me summarize advantages and disadvantages.
Advantages:
- You take less risk
- You can hold the position more time
- The margin is lower than the outright
- The Fed funds spreads and butterflies are an Exchange traded contract, so you don´t need a specific functionality in your trading platform
Disadvantages:
- Your trading fees are bigger
- It moves slower than other instruments
Fed Funds Spread Dec17-Dec18
Source: TradingView, Fed Funds Spread Dec17-Dec18, daily
This chart seems that is one of the above reverted, this is why it shows the differences between the Dec17 contract and the Dec18. If we compare all the charts above and this one, the last two months rounded in red, the Dec18 fell more than the Dec 17, which means that the spread is bigger between both contracts.
Fed Funds Butterfly, Dec17-Jun18-Dec18
Source: TradingView, Fed Funds Butterfly Dec17-Jun18-Dec18, daily
The butterfly is made up of three equidistant maturity outrights within the same product, so it contains 3 legs You need to buy the same amount of contracts in the first and third leg, and sell double of the contracts used in leg 1 in the second leg. The chart shows the following combination
+1 Dec 17 -2 Jun18 +1 Dec18
As you can see this product was in a range until September, and it’s been rising since then. This means that probably the traders expect an interest rate hike before Jun18.
I hope you enjoy this post. There are a lot of trading styles. You need to look for the one you feel comfortable with.
Have a good trading!
Disclaimer
I wrote this article myself, and it expresses my own opinions that shouldn't be used as a trading advice. Trading carries considerable risk due to the high leverages involved
