Long-dated eurodollar options

P

panaceus

Suppose I believe interest rates will rise over the next few years, and want to buy and hold long-dated eurodollar puts (say, June '13s). How should I decide which strike to buy?

I realize this is a ridiculous newbie question, but I have a history of not buying the best option for my purposes. And this impenetrable copy of Natenberg beside me suggests that I should ask a pro. Any advice would be much appreciated.
 
It's a tough question... It's really very difficult to answer a question this vague. The very first questions to ask are: a) how high do you expect rates to go up by Jun13; b) how much money in total are you willing to spend.
 
OKI-DOKI... Here's what my suggestion would be (treat with pinch of salt, as this is my individual opinion, nothing more). Eurodollar put skew is relatively expensive, which is understandable, while ATM vol is relatively low, which is also understandable. So, in my mind, this suggests that the best way to do this would be by buying put spreads. So, for example, the Jun13 99.00 - 98.75 (aka 90 - 87 using the mkt naming convention) put spread is at arnd 8.5 ticks (based on yest's close). So that means you're into the 3M LIBOR at 1.25% or higher in Jun13 trade at roughly 3:1 odds. Alternatively, you could look at smth like a 90-87-85 put fly, which looks like it's arnd 1.5 ticks. The payout there, if you manage to successfully pin the strike (i.e. 3M LIBOR settles at 1.25%), is 16:1, but you won't see your money until expiry.

Now pls keep the following in mind:
a) Jun13 is the 8th Eurodollar contract, so it's the furthest one where options are available and options started trading relatively recently; what this means is that mkt will be relatively wide and prices that I have used are indicative, based on yesterday's closes.
b) There's a whole lot of other contracts, variations, etc; I just looked at the most "vanilla" variety.
 
If I'm understanding you correctly,

"Eurodollar put skew is relatively expensive" = It's a relatively good value to sell OTM puts

"ATM vol is relatively low" = It's a relatively good value to buy ATM puts,
hence the recommendation is to buy a put spread.

I didn't follow the reasoning from "put spread is at arnd 8.5 ticks" to "So that means you're into the 3M LIBOR at 1.25% or higher in Jun13 trade at roughly 3:1 odds" though.

Also, would it make any sense to buy an ATM put (around 99.625 at the moment) rather than a spread? My intention isn't to pin the strike, and I'd like to profit if LIBOR rises beyond my expectations.
 
The reasoning behind the 3:1 odds is simple. Your put spread has a max profit potential of 25 ticks (assuming 3M LIBOR settles at 1.25% or above). Therefore, you're spending 8.5 ticks to make 25, which means arnd 3:1 (unless my brain has been addled by the global debt crisis).

Firstly, the ATM put isn't the one with the 99.625 strike. EDM3 is currently at 99 even, so that's the ATM strike. If you wanna buy that 99 even put, it will cost you 51.25 ticks. You will lose all of this premium, if your prediction is eventually proved wrong. However, in exchange your upside is unlimited in case LIBOR goes higher than 1%. So it's just a matter of you deciding what's probable and what's likely.
 
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