Treasury Futures Trading Primer

US Government Bonds market has been one of the best games in town over the last couple of years. Especially, if you adjust for the currency. Indeed, though the yields of Japanese and European bonds have declined (priced rose) more than those of Treasuries, the currencies of the respective countries have declined against the dollar. Thus international investors would have done better staying in US Bonds.

When what is supposed to be the safest investment of the world also outperforms most world’s risky markets, it is bound to draw attention from new ranks of investors.

As one of the most vocal “bond and dollar bulls”, I’ve been getting a number of questions regarding the interest rates markets both directly from my friends and via social media.

A long-time friend with a solid academic background asked a particularly interesting set of questions about trading Treasury Futures. In this post I will give our dialog almost verbatim, as I think it might be helpful to some novice traders and even contain some elements useful for more experienced ones. I will also insert some helpful questions and answers from my blog.

To preface the dialog I want to point out a few things.

  • Treasury futures might be awkward to trade for small investors as the unit contract has a $100,000 notional.
  • The actual mechanics of those futures (with convergence factors and cheapest-to-deliver) is rather complex. This post is not meant to teach this mechanics.
  • The advantages of trading Treasury futures are the price transparency and the level field. Through futures we can all enjoy the same economics of funding and carry, as any big bank, without hidden costs.
  • Finally, keep in mind, everything below is discussion points and not trade recommendations.

Email I

Could I again ask for your help with (hopefully, rather basic) questions about fixed-income trading? I am learning to trade treasury futures, and my questions are about the underlying math.

Q: The first question is about the cheapest-to-deliver bonds for futures contracts. Am I right in my understanding that, when yields are below 6%, the cheapest-to-deliver bonds are the shortest duration bonds (among those allowed by the contract spec)? For example, the cheapest-to-deliver bonds for the classic T-Bond futures would be 15-year bonds, the cheapest-to-deliver for the 10-Year T-Note futures would be 6.5-year bonds, and so on? If I am actually wrong, how do I figure out the cheapest-to-deliver bonds for each contract?

A: First, I want to be sure you understand modified duration – it appears that you do.

Duration = – d price / d yield

Modified Duration = Duration / Dirty Price   

When the prevailing yields are (like now) way below 6%, the cheapest-to-deliver is usually the shortest maturity allowable bond. But what really matters is modified duration, so in rare cases, a slightly longer bond with much higher coupon could have a shorter modified duration and be cheaper to deliver. Current cheapest-to-deliver for every contract can be looked up.

Q: The second question is about durations. How can I figure out the duration for a specific futures contract? For example, would it be right to assume that classic T-Bond futures are roughly equivalent to a 15-year bond with 6% coupon, and thus have duration of about 11 years?

A: In this rate environment the futures contract will essentially trade with cheapest-to-deliver (adjusted by the conversion factor). There will be some small technical factors, like the carry between the spot date and the delivery date, but they are not significant. However, it is incorrect to assume bond futures will always trade like a 15-year bond. In fact, currently they trade more like 20-year bond, because there do not exist any bonds with 15-19 year maturity. Those would have been the 30-year bonds issued during the Clinton era, when the long bonds were temporarily discontinued.

Q: Suppose I expect yields to rise (over the next few weeks or months), and I would like to take a position that bets on the rise of yields. Would it be reasonable to get a spread between 5-year and 10-year T-Note futures, that is, to sell short 10-years and buy an equal amount of 5-years? Are there better ways to bet on the rise of interest rates?

A:  Betting on rising yields has been a bad idea over the last 30 years and probably still is. Google “One Chart To Rule Them All” – my twitter post appears on the first page. Check it out.

Typically selling one thing and buying another just increases the amount things that can go wrong, so I almost never recommend such strategy to express a simple directional view. If you have a view on a specific forward portion of the yield curve, this could be a correct trade to express it.

Relative direction of interest rates is rather tricky. If the Fed were to start tightening soon, 5-year futures could go down, while 10-year futures not move at all. You could lose money, despite possibly having a correct view. Of course, the opposite could happen and you could make money on both sides.

Overall I would need to know your reasoning behind the bet to have an opinion whether the strategy is appropriate.

Email II

I have two follow-up questions.

Q: You mentioned that the cheapest-to-deliver for every contract may be looked up. Could you let me know where? Probably a trivial question, but I could not find these data.

A: To look up Cheapest-to-Deliver and risk ratios:

Q: You indicated that using a spread (buying one thing and selling another) is unnecessarily complex. Is there a simpler/better way to bet on rising yields? (The first thing that comes to mind is simply shorting, say, 10-Years, but I am concerned that doing so would be “swimming against the tide”, since I would be effectively paying the coupon on the shorted bonds.)

[From my blog

Q: When you say Long Bonds will carry if the Fed stays put, could you explain in simple terms what you mean ?

A: By carry I mean the difference between the yield on a bond and the rate at which a leveraged trader can borrow money overnight, using the bond as a collateral. In the current rate environment this borrowing (funding) rate for treasury bonds is virtually zero. If the Fed were to start raising rates, the funding cost would go up, making the carry trade less profitable.]

A: Getting a “free lunch” is not easy. When you do 5/10 spread, it might appear you are avoiding the negative carry, but actually you aren’t. The 5 year forward 5 year rate slides down rapidly as it goes to 4 year forward. The nature of betting against the bond market typically leads to negative carry.

Q: Also, here is an explanation of my reasoning behind my bet on the rising yields. I realize that my reasoning is naive–I am just learning the treasuries–but it may help you understand where my questions are coming from.

I expect that yields will rise at least a little–maybe by something between 0.25 and 0.40–in the next few months, and that, if they fall, they will not fall below the Jan. 30 minimum, and not for long. (From your email, I understood that you feel far less “bullish” about the rates–which is depressing. I really hate when they are that low.)

Given that expectation, I was trying to figure out some position that would allow me to bet on rising yields without “swimming against the tide”, i.e. without simply taking a short position and paying coupon on it.

First, I drastically reduced the duration of my bond portfolio, from about 12 years to about 5. This change was done in my positions in bond mutual funds and actual treasury bonds (not in treasury futures, which I have never traded before). Now, I am trying to to a similar thing with futures, mostly for thepurpose of learning how to use them, with small positions. I first considered doing a spread between Ultra T-Bond and Classic T-Bond, but even a single-contract position turned out too large for me (in terms of potential losses and margin requirements), so instead I am looking at a spread between 10-Year and 5-Year.

A: First – terminology: being bullish on rates means expecting rates to go DOWN (price language as opposed to funding language). So I am actually bullish, but only on the long-dated rates – I have no opinion on the short end.

[ From my blog

Q: Won’t Long Bonds fall if the Fed hikes rates ?

A: Over the last decade we have found out that the Fed cannot reliably control long-term interest rates with their overnight rate policy. In fact, when the Fed tightens, the market starts projecting lower inflation and slower economic growth for years in the future. Thus, long-dated rates often don’t move or move lower early in a hiking cycle.]

If you go deep to the reason why you want to make this bet, you might find ways to do this, without swimming against the tide – this is what Part III of my book is about.

For example,

  • If you think the inflation is going to be high, you might want to buy gold.
  • If you think the economy is going to do well – you can buy an established stock such as IBM with good dividend, so you will betting on strong economy and earning carry.

Finally, if you already have a preference for higher rates – remember by actually betting on higher rates, you are doubling down.

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If the market is a bubble, why so many stocks look cheap?


“The stocks in my portfolio are precious gems, immune to any problems in the system”. Yes, I know it’s a fallacy.

So, please, help me sort it out. I have been dragged into the raging debate on stock valuations. I have to confess, I feel out of my league on this issue, when engaging with such thorough experts as @Jesse_Livermore (, a moderate bull, or @jessefelder (, a moderate bear.

When I write about interest rates or currency, I possess (or at least project) much authority and experience. But I know relatively little about corporate valuations. My inclination to stay long equities over the last few years has been a function of my observing historical patterns and trends and my long-term portfolio strategy, but had little to do with whether I thought the overall market was still cheap.

So let me share my confusion. Reading various pieces on the overall US stock market valuations, I find the analysis ranging from fair to very expensive. Yet when I look at individual companies I know, so many of them still look like a bargain.

What DO I know? I mostly follow banks, tech, and social media. I know nothing of consumer, retail, utilities, biotech and so on.

Let’s start with banks. (I source P/Es from Yahoo! Finance).

$JPM  11.24;  $WFC 13.29;   $GS 10.97

Those guys seem to be priced for various degrees of bankageddon. Indeed, they don’t need any growth to justify their valuations, all they have to do is not to have all their earnings taken away by fines.

Established tech.

$IBM 13.49; $INTC 13.02

What is going out style? Computers or computer chips specifically?

All of the above enjoy a healthy growth of EPS via buyback and cheap funding. Some scoff at buybacks, but to me buying your own shares, when they are cheap, and locking the funding seems like a great investment.

Now let’s move to the growth sector.

$AAPL 16.82;  $GOOGL 26.85; $FB 74.65; $TWTR N/A

Are those the culprits of overvaluation?

$AAPL is certainly not as dirt cheap as it was a couple of years ago (similar to $INTC), but still doesn’t look stretched at all, given the power of their brand and continuing revenue growth.

In fact, all four companies above have virtually indestructible brands. There monetization is at different levels of maturity. But it’s hard to imagine any of them to be a terrible long-term gamble.

So where does the overvaluation lie? Is it all the biotech’s fault?