Why Bonds Matter?

Binary Options University May 23, 2016 Why Bonds Matter?

What does it mean when bond rates go up? This is a question that a lot of traders act upon, but don’t really know why or how it influences their trading decisions. The best way to approach the question is with a fictional example. If bond rates are currently set at 10 percent, that means you can buy a bond for $100, and in a year, it will be worth $110. That math is pretty easy. But, if rates drop down to 5 percent, now a $100 bond would be worth only $105 in a year. Again, still easy.

What ends up happening is that as bond rates shift, they can be more attractive at some times than they are at others. When they become more attractive, such as with the 10 percent return example above, more money goes into them. Because bonds are cash based, this helps strengthen the currency in question. In this case, that’s the U.S. dollar. This is one of the several reasons why there is a give and take between U.S. stocks and the price of the U.S. dollar compared to other currencies.

Now, let’s look at a real life example. When the Federal Reserve raises interest rates by 0.25 percent, what they are really saying is that your money (think the U.S. dollar) is going to be worth more in one year than it would have been a few months ago. By buying a bond after interest rates go up, your money will grow at a faster rate than if interest rates had stayed where they were—if you invest in bonds. This takes away some money from securities, such as stocks, because now bonds are more attractive. If interest rates were set at 0.75 percent before, and they have now gone up to 1.00 percent, your $100 will now return $1 in a year, instead of $0.75. In this instance, though, we are talking about billions of dollars, so it’s not just a quarter change we are dealing with, but millions of dollars or more. It shifts money away from business and into the government.

This is why it is such a big deal when the Fed even discusses interest rate changes. It shifts the momentum of where the money is going in the marketplace. Sometimes the impact isn’t a huge one, such as what we saw in December. That was a large impact, but it was very short lived, and markets had fully recovered by early April of this year. Sometimes, as what we saw in the 1980s and after the dot-com bubble, the impact can take over a year to fully be resolved. It’s important that we have both a short and a long term view when rates are changed. The short term view needs to gauge the public’s reaction, while the long term view needs to look at the fundamental decisions and math supporting the change. Short term panic is likely to drive asset prices down and the USD up against weaker currencies. The long term picture is much tougher to sort through, but it usually evens out over time. As you take out different length expiries for your binary options trading, keeping this balanced point of view will help you to avoid misinformed trades. The give and take isn’t a 100 percent negative correlation, so there is a possibility for short term trades to have a margin of error, but as long as you use strong timing of your trades and you take preventative measures when it comes to risk, your odds of making money trading using this knowledge are very good.

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