Trading Bonds

Bond Trading vs. Bond Investing

All securities can be invested in for various periods of time, either held indefinitely or in the case of derivatives, when the contract expires and must be exercised. These contracts can usually be rolled over though which means the old contract is closed out and a new contract is entered into with a new expiration date, so one can even hold futures longer term if one desires.

Positions that are held longer term, for a period of years, we call investing, with positions of a shorter duration being called trading. There is no essential difference between the two, as all investing requires placing trades and all trades are investing in the security for some period of time.

With bonds though, there is a particular distinction that separates trading with investing, as investing seeks to primarily earn income from bond holdings, while trading is much more interested in capital accumulation.

The degree that we may put more weight on one or the other goal will depend on our own goals, and this is certainly not cut and dried. The spectrum ranges from those who purchase 30 year bonds with the intention to hold to maturity, where the price at any given point in time during the 30 years does not matter, to those who only are looking to trade bonds for a few minutes, where price is the only consideration.

With bond trading, we rarely are concerned with yields themselves, as collecting yields involves holding bonds in a longer time frame than traders hold them. If you are in and out of your position the same day, or only hold for a few days or weeks, this just isn’t going to influence things, much like dividends aren’t really a focal point for stock traders.

Most stocks are invested in with the goal of capital appreciation though, with dividends being more like a bonus, but with bonds, it’s the income that matters the most here, and people don’t buy low sell high when investing in bonds really.

When bonds are traded, they do look to buy low sell high, or sell high buy low if it’s a short position, because the goal with bond trading is indeed capital gains. Bonds do not appreciate in price over time like stocks do, as they just move away from par value in one direction or another depending on the movement of interest rates, so over the long term we’re not looking for prices to go up or down in a sustained way over the life of the investment.

Bond prices certainly do move in meaningful ways in the shorter term, driven by things like interest rates, and in the shorter term, market supply and demand, and trading these movements is the focus of the bond trader.

Strategies for Trading Bonds

Just like with stocks, traders may rely on either technical factors, fundamental ones, or a combination of the two in order to seek to predict movements in price over a desired time frame. Fundamental considerations with bonds do tend to be priced in though to a large degree, and it’s not as if we can just anticipate that interest rates will go down and take long positions in bonds and expect to make a killing just on that, as if you see this, you can count that others will as well, to the degree that this is expected to affect things based upon the best knowledge at the time.

At the same time, we can’t just assume that these changes are fully priced in as there are other factors that affect bond price movements, most notably the fact that bonds are used as a hedge. It may therefore still pay to be aware of interest rate trends as prices just don’t mirror them, but on the other hand, if prices are being driven by something else, relying on expectations of rates may just end up steering you off course to some degree.

Whatever factors affect price all have their say, and the combination of all of these factors is expressed in the price itself at any given time. If rates are expected to go up for instance, with all things being equal, this should serve to reduce demand, but if people are fleeing the stock market and moving into bonds, this will have a positive effect on demand.

When the two forces collide in this case, their relative influence will be brought to light in bond markets itself, and this is where technical analysis, the study of price changes, will measure the effect of all market influences directly.

This is not to say that fundamental analysis doesn’t have its role in bond trading, and it’s considerably more relevant than fundamental analysis with stock trading, where it’s virtually meaningless, but in order to gain an advantage with this, we’re going to have to be very good at it, as good or better than average, in an arena that is dominated by huge institutions that hire the best analysts.

This is well beyond the ability or resources of the typical retail bond trader though, but we are still left with the ability to study price movements, where the rubber meets the road with fundamentals and everything else that may influence the price of bonds.

Technical Analysis Dominates All Trading

The good news is that since trading anything does involve shorter term time frames, technical analysis tends to be far superior to anything else when it comes to predicting these movements with sufficient accuracy.

Since the goal of bond trading is to focus and look to capitalize on price movements, studying these movements in order to discover the probable direction of them just makes sense.

The reason why so many people find trading so difficult is that they use approaches that are overly complex, far more so than is ideal, and the more factors you look at and need to weigh and predict, the more difficult the prediction is.

If, on the other hand, you are simply looking at an indicator on a chart of a bond and seeing if it is going up or down, that’s as simple as it gets with any sort of trading or investing, and that’s exactly what we need to do, to take all the guesswork out of the trade.

Many traders, including bond traders, do tend to guess a lot, which is never what we want, but this is due to a lack of skill really. When we look to measure momentum, we really need to seek out cut and dried ways to be able to tell what direction we’re likely to keep going in, or if we are about to reverse it.

The key is to be able to distinguish when the direction is changing in a meaningful enough way, and although markets do move up and down all the time in all time frames, the key is to find a strategy where the most money can be made over time with a given amount of trading capital while managing risk sufficiently.

The techniques that allow for successful bond trading are similar to what we would use in trading any financial instrument, which basically looks to measure trends in changes in price, taking into account the price movement itself, as well as other factors that traders may action such as support and resistance.

The only reason why support and resistance or other chart patterns are meaningful is because traders trade them, and this is true of everything that may influence prices, including the momentum itself.

To the degree that we can successfully predict these future price movements, resulting in our overall profit being greater than our losses, we will make money from trading. If we can do this while managing the drawdown risks of our trading capital, such that a run of bad luck within a successful strategy overall won’t hurt us, we have the makings of a successful trading plan.

Bond Prices Do Move in Predicable Ways

The best thing about trading, including bond trading, is that an individual with a fairly simple trading plan can compete with the largest and best institutional investors in the world, and make a good amount of money doing it.

Anyone looking at a bond chart can easily spot significant movements up and down in price, although the trick is to trade the more significant ones and ignore the moves of lesser significance.

There is no why here at all in doing this, as the why part is completely irrelevant. When we look at a chart and see that a certain strategy will predict the movement of price well enough to profit from, it makes no difference why this happens, it just does and we may take advantage of it.

Bonds, like everything else, undergo phases of accumulation and distribution, and this is especially true with bonds as some very large positions get bought and sold. These phases do drive prices, and the effect of retail traders is pretty insignificant actually when it comes to very liquid bonds such as those issued by the United States.

When larger players drive most of the action, this lends itself to more predictability, as huge positions simply cannot be traded instantly, and can take quite a while to place in the market. Smaller players like retail bond traders can ride the waves of these moves, and the greater agility by virtue of their much smaller trade size can be used as a significant advantage this way.

This is true to some extent with trading any security, but it is especially the case with bonds, as most traders don’t even have much of an idea that bonds can be traded. Bond trading has always been performed by institutions, as the cash bond market itself requires a lot of capital, so investors have until recently been limited to trading bond futures, although this trading can be pretty profitable.

These days, bonds can be traded with contracts for difference brokers, which brings trading bonds to the masses, and where the larger minimums to trade futures are no longer an impediment to smaller traders.

With the ability to trade bonds, commission free, and just pay the spread, along with a wide variety of bond trading products being offered, bond trading is now in reach of everyone who desires it.

When deciding to trade between different types of securities, as well as within types within a class of securities, it is important to become familiar enough with the options and weigh the relative benefits and risks in order to decide how to allocate your trading capital and what to trade, but trading bonds is at least worth a look, especially with traders who are looking to expand their horizons and even to look to diversify their trading portfolios more.