Although there are few internet forums dedicated to eurodollar trading and minimal mentions of them in social media trading circles, the eurodollar futures contract is arguably the most liquid product listed on the most active futures exchange in the world, the Chicago Mercantile Exchange Group.
If you are unfamiliar with eurodollar futures, it is a contract based on $1 million U.S. dollars deposited in overseas banks earning the three-month LIBOR interest rate. This might sound like an excessive contract size, but because short-term interest rates generally aren't volatile the eurodollar futures contract is a low-margin and relatively lower-risk market. For instance, a one to three-point move is generally seen from day to day, which equates to $25 to $75 per contract.
The eurodollar itself trades as a discount security tied to the USD LIBOR. For instance, if the eurodollar is trading at 97.50, it is implying a LIBOR rate of 2.5%. Thus, as the LIBOR moves higher, the eurodollar moves lower and vice versa. Because the deposits are located outside of the U.S., they are not subject to Federal Reserve standards and are considered to carry moderately higher default risk than funds located in the U.S. Thus, the interest rates paid on eurodollar deposits are generally higher than similar deposits on U.S. soil.
Those following LIBOR rates know that the USD rates are hovering well above 2% while the euro rates are moderately negative! To be precise, as of May 21, the three-month USD LIBOR was 2.33% while the euro three-month rate was -0.3534%.
Judging by history, the massive spread between the USD and euro LIBOR rates probably won't last; we are likely in store for some sort of mean reversion move that brings the euro LIBOR higher and the USD LIBOR lower. Further, eurodollars often experience a seasonal rally during the second half of the year and the chart suggests a breakout of the wedge pattern could prove to be explosive. Accordingly, we like the idea of purchasing call options in the December eurodollar futures market. This is a limited risk play looking for USD LIBOR rates to fall (and the eurodollar discount securities to rise).
Specifically, we like the idea of buying the December eurodollar 97.375 calls for about $200. This represents the total risk exposure (prior to transaction costs) and the profit potential is theoretically unlimited. Nevertheless, we would be targeting a move toward 97.60; if seen, the profit on this option could be somewhere between $375 and $500 per contract depending on how quick the move occurs (assuming it does).
Of course, if we are wrong, this option will slowly erode to nothing over the next six months. However, a lot can change between now and December and we think it is worth having a flyer in this market.