Trade Idea : Short gamma at the front end of the curve

Trade: Sell 100MM 6Mx2Y swaption straddles (atmf, strike = 3.57%)

Buy 67MM 1Yx2Y swaption straddles (atmf, strike = 3.86%)

The trade is vega neutral and should be actively delta hedged

Why do the Trade:

1) During a Fed pause shorter term rates tend to become more stable and delivered volatility
tends to drop. Chart 1 shows the 2-month delivered vol on 2Y swap rates during the first Fed
pauses averaged over the last 2 easing cycles. Dates used: 12/11/01, 11/17/98
2) During a Fed pause, uncertainty about the Fed’s actions get pushed out and implied vol for
longer expiries increases relative to shorter ones. Chart 2 shows the implied vol spread between
1Yx2Y and 6Mx2Y during the first Fed pauses averaged over the last 2 easing cycles. Dates
used: 12/11/01, 11/17/98

Chart 1
2-month delivered volatility on 2 year swap rates
11

10 Current 2-month delivered vol

9 2-month delivered vol on 2Y yields during the first Fed

pause averaged over the last 2 easing cycles
bp/day

4
0 25 50 75 100 125 150
Days following a Fed pause

Chart 2
0.5 Implied Vol Spread

0.3

1Yx2Y- 6Mx2Y
bp/day

0.1

-0.1

-0.3
0 10 20 30 40 50 60
Days following a Fed pause