Thread by @therobotjames

"Ask questions now? Or ask questions later?"

Imagine you are trading a futures product.

The prices of the futures as a function of their time to expiry looks like below.

You step away from the desk to make some tea.

And, upon your return, you see a different picture...

1/n

What happened to the Feb expiry?

It kinda sticks up.

The curve looks kinky now.

Why?

2/n

Could be many things:

1. Random large demand for that expiry has created temporary price impact, likely to revert
2. New info impacting that month is being priced efficiently
3. Somebody knows something and you're likely to see more demand come in behind in that expiry

3/n

Part of your job, if you are trading this product, is to know what is happening.

Is there anything that could impact Feb expectations, but not Jan and March?

But you can't always know everything and you need to work in probability weighted payoffs.

4/n

Say this product is interest rate futures.
(The "price" in this case might be 100 minus the yield.)

In this market, you might assume that 1 and 2 are more likely than 3.

So you'd look at the impact of being right and wrong in both these cases.

5/n

Take the first case. You don't know anything that could impact only that month.

So you think that kink might be caused by anomalous random demand. (People buy and sell stuff for all kinds of reasons.)

So you might do something like this.

6/n

You'd sell Feb, and buy (half as much of) Jan and Mar.

Essentially, you're looking to get paid to hammer out the kink.

And limiting exposure to changes in the overall level or slope of the curve.

So your expected return, if right, is the distance back to a non-kinky curve

7/n

Less the costs to trade.

You're selling a contract that is too expensive.

And you're buying two fairly priced futures (at least on average.)

Your expected returns come from the relative convergence of the expensive contract vs the fairly priced ones... less trading costs.

8/n

Now - what if you're wrong?

Depends how you're wrong.

If it's scenario 2: some news that that has been priced correctly by the market - then there's is not much expected downside to getting the trade on if you're wrong.

8/n

If the market priced this correctly, being wrong is quite benign.

You're buying two fairly priced futures and selling one fairly priced one.

Your expected return is zero, less trading cost.

9/n

In scenario 3, somebody knows something, and the market has under-reacted to it so far.

In this case the convergence trade has negative expectation.

You thought Feb was rich but it was actually cheap - and you expect to get run over.

10/n

So the optimal thing to do depends on the market and your assessment of the probabilities.

If 2 is more likely than 3, on average, then "get the trade on and ask questions later" is probably optimal.

If 3 is more likely than 2, then that will kill you.

11/n

In the highly liquid short term interest rate futures markets where I typically traded this stuff - 2 was more likely than 3.

So - I tried to be as informed as possible - but ultimately "ape in and ask questions later" was a reasonable trading approach.

12/n

However... if I'd tried to trade agricultural commodities, or the stuff @TCK_JRubano trades in this way, I might have been stretchered out of the building!

There's never an always correct answer in trading.

The only mistake is not thinking as clearly as possible.

13/13. Fin.

Mostly inspired by this:

https://twitter.com/SinclairEuan/status/1459514233276751874?s=20