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Regime changes in automated trading

Published in Automated Trader Magazine Issue 42 Q1 2017

The term structure of interest rates provides many opportunities for systematic traders. The level, slope, curvature and volatility of interest rate markets are all heavily regime-dependent. Early identification of changes in regime is key for developing successful trading strategies.


Joseph Choi

Joseph Choi publishes the Curve Advisor strategic newsletter. He previously worked as a senior proprietary trader in J.P. Morgan's Global Currencies and Commodities Group. For years he traded well over 10 million Eurodollar futures and options contracts annually - by hand, without an algo. Mr. Choi is still recuperating.

Automated trading is backward-looking. It is typically based on historical data - whether it is pricing data, behavioral data or both. It is presumed that by understanding the secrets of the past, one can succeed in the future. Depending on the algorithm and the markets, this could be somewhat true. However, there are important considerations that should be taken when analyzing interest rate historicals. This is an introductory discussion of the importance of understanding interest rate regimes when looking at past data and trying to apply it in the future.

For the purposes of this article, I will refer to the US Federal Reserve and Eurodollar interest rate futures. But the concepts can apply to other central banks and other interest rate products.


Many traders tend to think mostly of one dimension - up or down. But there are other meaningful dimensions with interest rate trading because of the availability of: (1) various settlement dates (for example, there are liquid short-term interest rate futures in quarterly intervals out to five or more years), (2) options for all strikes for each of those contracts and (3) spreads between various interest rate instruments (across products and countries).

One of the beautiful features of interest rates is that there is a strong relationship between one part of the yield curve and an adjoining part of the curve. The fact that there are so many interrelated contracts to choose from gives us an opportunity to find additional value. Consider the following betas and correlations for ED13 (the 13th generic Eurodollar futures contract) for the past year in Table 01. If we had to hedge a position in ED13, we have a number of reasonable alternatives - especially in a high-frequency trading setting. One also has many more opportunities to scalp a tic if an eager counterparty were to trade a contract on the wrong side of the bid/ask spread in a particular contract.

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