Introduction
Many traders in fixed income and options markets build their strategies by taking a directional position on a particular asset, speculating on the change in interest rates or volatility of a security in a given time period. However, it may not be ideal to have such significant exposure to a single directional change which may leave them exposed to large losses in periods of high market uncertainty. The current market environment has become increasingly unpredictable over the last year, with the actions of central banks remaining unpredictable due to opposing views on how they should deal with balancing high levels of inflation and slowing economic growth. On top of this, the wars in Ukraine and Israel, as well as consistently high tensions between the U.S. and China have led to unpredictable changes in volatility. Therefore, in this article, we will explore the role of Steepeners and Flatteners, useful trading strategies that allow investors to trade not on an absolute change in parameters, but on the relative change of the underlying price-determining variable (in our cases, interest rates and implied volatility).
Trading the Yield Curve
Traders in bond markets can take long or short positions on the interest rate, taking advantage of the inverse relationships between prices and rates. If interest rates are expected to increase, bond prices are expected to fall, and traders can benefit from short-selling bonds. On the other hand, if interest rates are expected to fall, bond prices are expected to rise, allowing traders with long positions to profit. However, these strategies leave traders exposed with no protection in case their predictions turn out to be inaccurate; this is where Steepeners and Flatteners come in.
The yield curve is the backbone of these strategies, describing the relationship between bond yields and their maturities. Interest rate Steepeners and Flatteners allow traders to speculate on the changes in the slope of the yield curve, ie. the relative change in yields of long- and short-term maturities, rather than speculating on the level of interest rates themselves.
Steepeners
In case a trader expects that the slope of the yield curve will increase, they can enter into an interest rate Steepener. This entails buying bonds with short-term maturities and going short bonds with long-term maturities, since we expect that the difference between short-term and long-term rates will increase.
This strategy is neutral regarding the direction of the future macroeconomic environment (and thus the interest rates set in response by central banks), as it allows traders to profit regardless of an interest rate increase or decrease. What counts with Steepeners is that we remain in one of following two scenarios:
Long-term rates increase by more than short-term rates:
Short-term rates decrease by more than long-term rates:
Flatteners
In case a trader expects that the slope of the yield curve will decrease, they can enter into an interest rate Flattener. This entails buying bonds with long-term maturities and going short bonds with short-term maturities, since we expect that the difference between short-term and long-term rates will decrease.
This strategy is still neutral regarding the direction of the future macroeconomic environment. What counts with Flatteners is that we remain in one of the following two scenarios:
Long-term rates decrease by more than short-term rates:
Short-term rates increase by more than long-term rates:
Trading the Implied Volatility
Implied volatility is a key input in the Black-Scholes option pricing formula. It consists of the expected volatility of the options’ underlying asset, backed out using current option market prices. When traders buy options, they expose themselves to the price of the underlying asset, as well as its implied volatility. Traders who buy options, regardless of whether they are calls or puts, are long on implied volatility, meaning that an increase in volatility will increase their options’ value (option sellers on the other hand are short on implied volatility). This leaves them exposed to scenarios in which the actual implied volatility is lower than their forecasts, entailing that their options are worth less than they had predicted.
Similarly to how interest rate traders consider the yield curve, option traders look at the implied volatility curve, which represents the relationship between implied volatility and maturity for a given strike. Steepeners and Flatteners allow investors to profit from relative changes in the implied volatility, without having to take a directional stance.
Steepeners
In case a trader expects that the slope of the volatility curve will increase, they can enter into a volatility Steepener. This entails buying options with long-term maturities and going short options with short-term maturities, since the trader expects that the difference between short-term and long-term implied volatility will increase.
Again, for the Steepener to lead to profits, we need to be in one of the following states:
Long-term volatility increases by more than short-term volatility
Short-term volatility decreases by more than long-term volatility
Flatteners
In case a trader expects that the slope of the volatility curve will decrease, they can enter into a volatility Flattener. This entails buying options with short-term maturities and going short options with long-term maturities, since they expect that the difference between short-term and long-term implied volatilities will decrease.
For a Flattener position to be profitable, a trader wants to find themselves in one of the following two scenarios:
Long-term volatility decreases by more than short-term volatility
Short-term volatility increases by more than long-term volatility
Example of an Interest Rate Steepener
In order to more easily comprehend how these strategies function, we propose this example: imagine you are a trader active in fixed income markets and you are not sure how interest rates will change in the current environment. In this situation it is hard for you to decide whether to buy or to short sell bonds since you can't predict if interest rates will fall or rise. However, the trader notices that the yield curve is inverted (as it is today) and is convinced that the yield curve will return to normal. In this case, you would engage in a Steepening strategy since the slope of the yield curve is expected to increase (going from negative to positive), and you would buy short-term bonds and short-sell long term bonds. This allows the trader to be indifferent regarding the absolute level of interest rates and simply benefit from the increase in the slope of the yield curve.
Conclusion
As we have seen, Steepeners and Flatteners can be used to mitigate directional exposure to interest rate and implied volatility changes when investing in bonds and options. These strategies are particularly relevant in today’s unstable macroeconomic and geopolitical environment, which has led to high levels of market unpredictability. It is for these reasons that we believe Steepeners and Flatteners are particularly relevant in today’s trading environment, since they are relatively immune to these shocks and allow traders to profit without relying on unstable and unreliable directional forecasts.
References
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Chen, J. (2022a) Bear flattener: Definition, meaning, vs. Bear Flattener, Investopedia. Available at: https://www.investopedia.com/terms/b/bearflattener.asp (Accessed: 13 November 2023).
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Schneider, H. and Derby, M. (2023) Fed keeps rates unchanged, Powell Hedges on possible end of tightening campaign, Reuters. Available at: https://www.reuters.com/markets/us/fed-poised-hold-rates-steady-despite-economys-bullish-tone-2023-11-01/ (Accessed: 13 November 2023).
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