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The 10-year Note and 30-year Bond futures markets are the most fascinating markets to trade in. No other markets have such close ties to the stock market and the economy as a whole other than the stock indices themselves. They can be used as the proverbial "canaries in the coalmine" and give a good indication of where this economy is going. Despite this, many traders I speak with stay away from these markets because of their aura of mystery. Until now. In this article, I will be breaking down how these markets work and how I believe a trader can capitalize on the opportunities that present themselves.

First, let us look at what makes up a Note and Bond futures contract. All a Note or Bond really is a loan from one entity to another with a payment stream. The unique feature about these loans is that it is the U.S. government getting the loan. In this Note or Bond you have four basic components: principal, coupon rate, price, and yield. Principal is the original loan amount, For Notes and Bonds the standard contract is for $100,000. The coupon rate is the original rate on the Notes and Bonds, The standard rate is 6%. These first two components do not change. The other two components do change. Price is how much is paid to receive the payment stream on the on the bond. To get the price of a bond, divide how much is paid for the bond by the principal amount and multiply by 100. If the purchaser of the loan only pays $100,000, it is said that he paid "par" for the loan or 100.00. And yield is the actual interest rate received depending on how much is paid for the loan. If the buyer of the loan paid $100,000 or "par" he will get 6% for his yield.

Here's where it gets interesting. Let's assume that the economy is doing well. Let's say that an investor can put his money elsewhere and get 7 or even 8%. Obviously, 6% will not do. In order for a person to purchase this bond now they would want to pay less than $100,000. Let's say $90,000 or even $80,000. Now remember, the original terms of the bond have not changed. It will still pay 6% on $100,000 or $6,000. But, since the buyer of the bond paid less than the original amount of the bond he will get the yield of 7 or 8% he is looking for. In this particular case, the buyer of the bond would only have to pay $80,000 or 80.00 in order to get 7.5% yield.

Let's now take a look at the other scenario. Let's say that the economy is doing poorly, let's say that investors now just want the safety and security of a government bond because they want that assured income stream. Suddenly, investors are willing to pay more than $100,000 to get that $6,000 or 6%. They might pay $110,000 or even $120,000. If an investor paid $120,000 or 120.00 for the $100,000 bond that paid 6%, his yield now become 5%.

    $6,000/$120,000=5%

Notes and Bonds purchased with a price greater than 100.00 are known as being bought or sold on a premium.

From the preceding exampling we can then come to the conclusion that bond prices and yields have an inverse relationship. When bond prices go up, interest rate yields go down and when prices go down, yields go up. Also, since the U.S. government is backing the loan we can see how it is viewed as a safe haven in times of uncertainty. When investors no longer can handle risk in the stock market or other investment vehicles, they tend to buy bonds and vice versa. You can watch the stock market and bond market react to each other depending on risk tolerance. We will now look at the movements of the e-mini S&P and the 10-year bond future as an example of this phenomenon.

To see an example of this, view a chart of the e-mini S&P and the 10-year Note for similar time frames. As one can see, when the S&P and the 10-year Note are trending, they tend to move in opposite directions. Trading opportunities present themselves when the trends come to an end. More often than not, a turn in either the stock or the bond market will usually accompany a turn in the other market with in a short period of time. This illustrates the ebb and flow of investor risk tolerance in the overall marketplace. In my opinion, timely recognition of a turn in one market before a turn in the other can produce an excellent entry point for a trade.

Another trade possibility using bonds is in the form of spreads, namely, the "NOB" spread. "NOB" stands for Notes Over Bonds. This is a more advanced play using the 10-year Note and 30-year Bond contracts to capitalize on changes in the yield curve. For those who are unfamiliar with the yield curve, this is the relationship between shorter term Notes and longer term Bonds. Basically, in normal markets, people will pay less for Bonds because it ties up funds for longer periods. This implies that the prices for 10-year Notes will be higher than 30-year Bonds. If you then incorporate the other conclusion that we just came to that prices and interest rates have an inverse relationship, the rates for Bonds will be higher than Notes. Given this, the chart comparing relative interest rates for the two should be a nice upward-sloping graph showing higher interest rates as the terms get longer. This is the "normal" yield curve. An "inverted" yield curve is just the opposite. In this scenario, Note prices are higher than Bonds resulting in a downward sloping graph showing lower interest rates. The "NOB" spread works the best when the yield curve changes from "inverted" to "normal" or "normal" to "inverted".

A typical "NOB" spread is constructed like so. First, purchase (go long) two 10-year notes then sell (short) one 30-year bond. The reason for the 2:1 ratio is that the 10-year note is more responsive to market conditions than the 30-year bond. Now all that is required for the trade to be profitable is for the 10-year and 30-year bonds to move up in similar price increments. For example:

The Trade Center Pro Challenge

Register today for the Trade Center Pro Challenge, a complimentary on-line fantasy futures trading contest. Simply manage a $50,000 fantasy futures trading account for two weeks and you could be eligible to win one of the weekly prizes, or the Grand Prize - 1 oz of gold! Join now! It's complimentary!