Four ways to trade interest rates
Exchange Traded FundsETFs are the easiest way to trade interest rates for most people. ETFs generally replicate a major index such as the Lehman or Barclays 20+ Year Index. You can buy and sell them just as you would a stock. These instruments are actively traded so that in most cases you can easily enter or exit a trade at the current market price without giving up much of your profit due to the bid-ask spread. A number of companies provide ETFs on Interest Rate Products. You can find this information at the Stock Exchange website Exchange Traded Funds for providers, products and ticker symbols. By using ETFs, you can play the underlying index to either rise or fall depending on your outlook. If you wish to leverage your position without incurring broker margin interest costs, you can purchase ULTRA instruments. These instruments move twice as much as the regular ETF. Index Options If you want to further leverage your position, you can purchase Options on an interest rate index. The Chicago Board Options Exchange (CBOE) offers both call and put options on a number of interest rate indices ranging from 13-weeks to 30-years. Put options give you the right (but not the obligation) to sell the index at a specific rate at a given time in the future. Call options give you the right (but not the obligation) to buy the index. Option prices cost only a fraction of what an ETF might cost but in order to profit from your option purchase, the index must move in the direction you wish within a given amount of time. Should the index not move sufficiently within this period of time, you could lose all of your investment. However, if you are correct in your assessment of the market and your market timing is correct, you can reap large percentage profits. Futures ContractsFor larger investors, Futures might be the way to go. Futures contracts are traded on the Chicago Mercantile Exchange and the Chicago Board of Trade, depending on the interest rate maturity. Futures contracts are different than options. They are actual contracts and give you the obligation to buy or sell a product in the future. Most futures contracts do not result in the actual delivery of a product. Rather they are closed out through offsetting transactions. Yet the amount of leverage that a futures contract can provide is much greater that the other products we have discussed. Shorter-term maturity futures allow one to control $1 million while longer-term maturity contracts cover $100,000. The margin, or amount required to deposit, to control these positions are usually under $5,000. As a result, you can win or lose substantial amounts of money by using futures. Options on FuturesTo obtain this great amount of leverage with reduced risk, the futures exchanges also provide Options on Futures. Just like stock or index options, Options on Futures allow you to bet on the price movement of a futures contract by giving you the right (but not the obligation) to buy or sell a futures contract at a given price in the future. Risk Management the KeyWhatever method you choose to participate in a market move, you must understand your risk tolerance and employ risk management techniques. You must know how much you can afford to risk and have a plan of action to exit a position when you are not right. The more leverage you use, the greater your risk will be so you must be totally disciplined or your losses could well exceed the amount that you place for margin. No matter how big your portfolio is, diversification is always an important factor in long-term success. Be sure to talk with your financial adviser to be sure that you are diversified as well as positioned properly for future market trends. If your adviser is not well-versed in all of the investment products described above, consider finding a new adviser who can provide you with all of the trading instruments you need to prosper in the 21st century.
Gary Lewis' ideas incorporate more than 30 years working with investments including 20 years experience in the derivatives industry and 10 years as a fee-only comprehensive financial planner. He specializes in designing portfolios that meet the client's required rate of return with a minimum level of volatility. You can read his writings on financial markets at Asset Design Center.View all articles by Gary Lewis
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