(Bloomberg) -- An options-based source of fuel for the Treasury market rally may be drying up.
Short-volatility structures, made from options on Treasury futures, can add momentum to a move in yields. Changes in yield affect the quantity of futures needed to hedge the positions, in a way that can spur buying in a rally and selling in a sell-off.
The structures have run into trouble as volatility has taken off. As measured by 3-month/10-year swaption volatility, a benchmark, it plunged to near record lows in early May. Structures initiated at that point have fared poorly as the escalation of U.S.-China trade tensions moved yields away from the targeted strikes and the volatility benchmark back toward its highest levels of the year.
CME Group Inc. (NASDAQ:CME) open-interest data for Wednesday suggest that a large purchase of a bond strangle -- combining a lower-strike put and a higher-strike call -- was done to exit a short-volatility position at a loss of as much as $12.6 million on the options. To be sure, if it was hedged with a long in Treasury futures, the trader’s net result was better, if not good.
Such structures became popular in early May, and their accompanying hedges bear some responsibility for the drop in Treasury yields to multimonth lows. If others follow in dumping them, that could help put the brakes on the rally.