Advanced Trading Strategies

Let’s look at some advanced trading strategies.

Some of these strategies might not be directly pursuable for most traders – though some are – but they can show the variety of what’s possible, provide awareness, and inspire creativity:

Mortgage Basis Trade (Long/Short MBS Pools vs. TBA)

This strategy involves taking positions in mortgage-backed securities (MBS) pools and offsetting them with positions in the “to-be-announced” (TBA) market, which represents a forward contract for the delivery of MBS pools.

Traders try to profit from the price discrepancies between the two markets. Namely, MBS pools with specific characteristics may trade at a premium or discount to the TBA.

CDS Basis Trade (Long Bond/Short CDS or Vice Versa)

This trade involves taking opposing positions in a bond and its corresponding credit default swap (CDS).

Traders go long the bond and short the CDS, or vice versa, to exploit pricing inefficiencies between the two markets.

The goal is to capture the basis, which is the difference between the bond’s yield spread and the CDS premium.

On-the-Run/Off-the-Run Treasury Basis Trade

This strategy capitalizes on the yield differences between the most recently issued (“on-the-run”) Treasury securities and older (“off-the-run”) issues of the same maturity.

Traders try to profit from the yield spread between the two types of securities, as on-the-run Treasuries typically trade at lower yield due to higher liquidity.

Interest Rate Swap Spread Arbitrage

This trade involves taking opposing positions in interest rate swaps and Treasury securities of the same maturity.

Here you’re looking to profit from the spread between the fixed rate of the swap and the yield of the Treasury bond.

The trade is based on the assumption that the spread will converge towards a historical norm and allow traders to capture the difference.

Covered Interest Rate Parity Arbitrage

This strategy exploits deviations from the covered interest rate parity condition, which states that the interest rate differential between two currencies should be equal to the premium or discount in the forward exchange rate.

Traders borrow in the low-interest currency, convert the funds to the high-interest currency, invest the proceeds, and simultaneously enter into a forward contract to sell the high-interest currency at the prevailing forward rate.

If the trade is executed correctly, the trader can lock in a risk-free profit due to market inefficiencies.

Convertible Bond Arbitrage

This strategy involves taking opposing positions in a convertible bond and the underlying stock.

With this, you try to profit from mispricing between the convertible bond and the theoretical value derived from the stock price and the bond’s characteristics.

They typically go long the convertible bond and short the underlying stock, or vice versa, depending on whether the bond is undervalued or overvalued relative to the stock.

Capital Structure Arbitrage (Bonds vs Loans vs Stocks)

This strategy exploits pricing inefficiencies within a company’s capital structure, such as bonds, loans, and stocks.

Traders try to identify relative mispricing among these securities and take opposing positions to capture the price convergence.

For example, they may go long an undervalued bond and short an overvalued stock of the same company, or vice versa, to profit from the eventual convergence of the securities’ prices.

Curve Arbitrage (Across Different Maturities)

This strategy involves taking opposing positions in interest rate instruments with different maturities along the yield curve.

The idea is to profit from mispricing between various points on the yield curve, such as the difference between short-term and long-term interest rates.

They might go long one maturity and short another, or construct more complex strategies using various combinations of interest rate instruments.

The goal is to capture the eventual convergence or divergence of rates across different maturities.

Municipal Bond Relative Value Trades

These trades involve identifying and exploiting relative mispricing between different municipal bonds.

Traders analyze factors such as credit quality, sector, geography, and maturity to identify undervalued or overvalued bonds.

They’ll go long positions in bonds they believe are undervalued and short positions in overvalued bonds, or construct more complex strategies involving multiple bonds.

The goal is to profit from the convergence of bond prices to their fair values as market inefficiencies are corrected.

Sovereign Debt Basis Trades

This strategy involves taking positions in sovereign bonds and hedging the exposure using credit default swaps (CDS) or other instruments.

Here you try to profit from the basis, which is the difference between the bond’s yield spread and the CDS premium.

Traders may go long the bond and short the CDS, or vice versa, depending on whether the basis is positive or negative.

The trade is based on the assumption that the basis will converge toward a historical norm.

Emerging Markets External/Local Debt Arbitrage

This strategy capitalizes on pricing inefficiencies between emerging market sovereign debt denominated in different currencies.

Traders analyze the relative value of these countries’ external debt (denominated in foreign currencies, such as USD) and local debt (denominated in the local currency).

They may take long positions in undervalued debt and short positions in overvalued debt, or use derivatives to construct arbitrage strategies.

They try to benefit from the convergence of prices between external and local debt markets.

Securitization Arbitrage (ABS vs. MBS)

This strategy involves identifying and exploiting pricing inefficiencies between different types of securitized products, such as asset-backed securities (ABS) and mortgage-backed securities (MBS).

Those in these markets look at factors like underlying collateral, credit quality, and prepayment risks to identify mispriced securities.

They may go long undervalued securities and short overvalued ones, or use more complex strategies involving multiple securities or derivatives.

The goal is to capture the eventual convergence of prices between different securitized products as market inefficiencies are corrected.

Index Arbitrage (Cash Bond Portfolio vs. CDX)

This strategy involves taking offsetting positions in a portfolio of cash bonds and a credit default swap index (CDX).

Traders look to profit from pricing discrepancies between the two markets. They construct a portfolio of bonds that closely replicates the composition of the CDX index and take an opposing position in the CDX.

The goal is to capture the basis between the cash bond portfolio and the index, under the assumption that the prices will converge over time.

Volatility Arbitrage (Options vs. Realized Vol)

This strategy exploits mispricing between options and realized volatility.

Traders analyze the implied volatility priced into options and compare it to historical or expected future volatility levels.

If options are overpriced (implied volatility is higher than expected), traders may short options.

Conversely, if options are underpriced, they may go long the options.

The goal is to profit from the convergence of implied volatility and realized volatility over the option’s lifetime.

Correlation Convergence Trades

These trades try to profit from mispricing in the correlation between different assets or securities.

Traders analyze the historical or implied correlation between assets and construct positions that benefit from deviations from the expected correlation levels.

Strategies may involve taking positions in different tranches of structured products, or using options and other derivatives to capture changes in correlation dynamics.

Mortgage Derivative Basis Trades

These trades involve taking offsetting positions in mortgage derivatives (e.g., interest-only or principal-only strips) and other mortgage-backed securities (MBS).

Here they’re trying to exploit pricing inefficiencies between these instruments by going long one and short the other.

The goal is to capture the basis, or the difference in pricing between the derivative and the underlying MBS, under the assumption that the prices will converge over time.

Equity/Fixed Income Relative Value

This strategy involves identifying and exploiting relative mispricing between equity and fixed-income securities of the same company.

Traders analyze factors such as credit risk, volatility, and market sentiment to determine whether a company’s equity or debt is over or undervalued relative to the other.

They may go long the undervalued security and short the overvalued one, or construct more involved strategies using derivatives.

The goal is to profit from the eventual convergence of the two securities’ prices as market inefficiencies are corrected.

This trade capitalizes on the different pricing dynamics and risk factors affecting equity and fixed-income markets.

Cross-Currency Basis Swaps Arbitrage

This strategy exploits pricing inefficiencies in the cross-currency basis swap market.

Cross-currency basis swaps involve exchanging principal and interest payments in one currency for those in another currency.

Traders look at the pricing of these swaps relative to the implied pricing from other related markets, such as foreign exchange forwards and interest rate swaps.

They’ll look to make money from deviations from theoretical pricing relationships by taking offsetting positions in the basis swap and related instruments.

The goal is to capture the basis, or the pricing discrepancy, as it converges towards theoretical fair value.

Inflation Basis Trades (TIPS vs. Swaps)

This strategy involves taking offsetting positions in Treasury Inflation-Protected Securities (TIPS) and inflation swaps.

TIPS provide protection against inflation by adjusting their principal value based on changes in the Consumer Price Index (CPI), while inflation swaps allow traders to exchange fixed payments for floating payments linked to inflation.

Traders analyze the difference between the inflation compensation priced into TIPS and inflation swaps, known as the “inflation basis.”

They may go long TIPS and short inflation swaps, or vice versa, to profit from the convergence of the inflation basis towards historical norms or target levels.

This type of trade can also be used or structured to achieve some other strategic goal, such as having the portfolio better protected from inflation over time.

Credit Contingent Notes Relative Value

This strategy focuses on identifying and exploiting relative mispricing between credit contingent notes (CCNs) and other credit-related instruments, such as corporate bonds or credit default swaps (CDS).

CCNs are debt securities that transfer a portion of the credit risk from the issuer to the investor, with the principal amount adjusted based on the credit performance of a reference entity or portfolio.

Traders analyze the pricing of CCNs relative to the underlying credit risk and compare it to the pricing of other credit instruments.

They may take long or short positions in CCNs and hedge with opposing positions in bonds, CDS, or other derivatives.

They’ll then hold to try to profit from the convergence of prices as market inefficiencies are corrected.

Callable/Putable Bonds vs. Vanilla Arbitrage

This strategy involves taking offsetting positions in callable or putable bonds and vanilla (non-callable/non-putable) bonds of the same issuer.

They look at the pricing of the embedded options (call or put) in the callable/putable bonds relative to the vanilla bonds, aiming to identify mispricing.

Traders may go long the undervalued bond and short the overvalued one, or use derivatives to construct arbitrage positions.

The goal is to capture the relative value discrepancy as the option-adjusted spreads converge.

Mortgage Refinancing Spread Trades

These trades capitalize on the spread between mortgage refinancing rates and prevailing mortgage rates.

Traders monitor the incentive for homeowners to refinance their mortgages based on interest rate movements.

They may take positions in mortgage-backed securities (MBS) or related derivatives that benefit from either an increase or decrease in refinancing activity.

The goal is to profit from the widening or narrowing of the refinancing spread as interest rates fluctuate.

Asset-Backed Commercial Paper Arbitrage

This strategy involves exploiting pricing inefficiencies between asset-backed commercial paper (ABCP) and other short-term funding instruments.

ABCP is a form of short-term debt secured by underlying assets, such as trade receivables or loans.

Here, traders will look at the yield spreads of ABCP relative to other money market instruments and try to identify mispricing.

They can go long undervalued ABCP and short overvalued instruments.

CLO Tranche Relative Value Arbitrage

This strategy focuses on identifying and exploiting relative mispricing between different tranches of collateralized loan obligations (CLOs).

CLOs are structured finance products that repackage corporate loans into tranches with varying levels of risk and return.

They’ll try to identify undervalued or overvalued tranches by looking at things like:

• credit quality
• subordination levels
• market demand

Traders will take long positions in undervalued tranches and short positions in overvalued tranches to profit from the convergence of prices.

Dividend Arbitrage using Bond/Equity Positions

This strategy involves taking offsetting positions in a company’s bonds and equity to capitalize on pricing inefficiencies around dividend payments.

Traders analyze the expected dividend payment and its impact on the company’s bond and stock prices.

They may go long the undervalued security (bonds or stocks) and short the overvalued one around the ex-dividend date.

They can capture the mispricing caused by different tax treatments and market participants’ reactions to dividend payments.