Jump into trading US Treasury futures with an explanation of Interest Rate Futures.

Interest Rate Futures Contract

An interest rate futures contract is a futures contract with an underlying instrument that pays interest. To understand interest rate futures, it’s important to understand a little bit about treasury futures and interest rates.

Current State Of Treasury Notes

As the US government’s debt matures and expenditures increase, the bond market is utilized to finance the growing debt and expenditures. By the end of 2014, the government had nearly $14 trillion of outstanding bonds and notes used for these purposes.

Inverse Relationship: Yields to Price

Something that throws off new interest rate futures traders is the inverse relationship between yields (interest rates) and interest rate futures prices. Meaning that when interest rates increase, the price of bonds decrease and when interest rates decrease, the price of bonds increase.

For example - interest rates are near an all-time low and are expected to go up after the next fed announcement. If rates do go up as a result of the announcement, then that means that bond price will go down. If I expected interest rates to go up, then I would want to sell (or some variation of a short strategy) treasury futures because the increasing interest rates would drive down the price of bonds.

Why Trade Treasury Products?

Three reasons that futures traders like treasury products are because:

• They are liquid
• They are secure assets (AAA rated securities)
• Diversity (different maturity timeframes)
  

Another great thing about treasury futures is there may be no other tradable asset that offers a direct link for exposure to economic events with such liquidity and transparency.

Interest Rates Futures Pricing

Some of the most heavily traded futures contracts in the world are the Classic bond, 10-year note, and the 5-year note.

These three types of futures contracts shares common elements. Each contract:

• is based on $100,00 par values
• is traded in tics and points
               -each point has 32 tics (1pt = 32t)
               -each point has a value of $1000
               -each tic is $31.25 ($1000/32 = $31.25)
  

The only difference between the three is that the 5-year note is traded in 1/4 tics $31.25/4 = $7.8125 and the 10-year note is trades in 1/2 tics $31.25/2 = $15.625.

Interest Rates Futures Pricing/Quote Example

If you wanted to find the par value for a US Treasury futures contract quoted at 128 ’30, the math would look like this:
$1000 x [128 + (30/32)] = $1000 x 128.9375 = $128,937.50.

Options On Interest Rates Futures

If you are looking to trade options on interest rate futures, it is important to understand how the pricing for those work as well. The options contracts on interest rate futures are 1/64 of a futures contract point.

The math for each option contract tic would be:
(1/64 x $1000) = $15.625

Because options tics are 1/64 instead of 1/32, we have to do a small bit of mental math to convert the tic in the quote to the options tick value. If the quote was 128 ’03, it would represent 128 plus 3/32. This would translate to an options value of 128 plus 6/64. See what we did there?

Another example would be if the quote were 130 ‘035. In terms of options tics, it would represent 130 plus 3.5/32, which translates to 130 plus 7/64.

Options On Interest Rates Futures Example

Now, let’s look at how this translates to an options on interest rate futures strategy…

In this example, we will be using a call spread. Our assumption is that interest rates will remain unchanged or go up by the expiration in September (remember that interest rates are inverse to interest rate futures prices so increase yields create decreasing prices). For this example, we look to the /ZN (10-year note) future.

If we wanted to find the value of each leg of the contract, we will need to do a little math.

If we were looking at the Sept 126.5 call, and it is quoted at “57, then we would translate that to futures points to get the value of the option, In this case, it would be:
1 + (57/64) = .890625 futures points
Then to find the value, we multiply .890625 x $1000 (value per futures point) = $890.625
Or simply:
57 ticks X $15.625 = $890.625

Let’s pretend that the Sept 128 call is quoted at 0 “29. To get the value of the contract, we would do the following:
0 + (29/64) = .453125 futures points
To find the value, we again multiply the futures points number by $1000. $1000 x .453125 = $453.125.
Or simply:
29 ticks X 15.625 = $453.125

If we wanted to find the maximum potential profit from this, we simply subtract the long call value from the short call value:
$890.625-453.125 = $437.50/position.

If you enjoyed this segment, check out this episode that expands on the yield curve mentioned in this episode.

Underlyings: /ZT (2 Yr T-Note), /ZF (5 Yr T-Note), /ZN (10 Yr Note), /ZB (T-Bond), /UB (Ultra T-Bond)

Strategies: Options on Futures - Vertical Call Spread