The Risks of Floating versus Locking

Introduction
Occasionally the question arises about what is meant in the Mortgage Market Guide by “the risks of locking…” or “the risks of floating…” For example, in a recent issue the statements “The risks of locking stand at about 19bp in lender price (points, not rate) to the first resistance level of $100.28” and “The risk of floating is approximately 9bp to the first support level of $100, 31bp to the next support level at $99.69, and 81bp to our third level of support at 99.19” were made. Before clarifying what we mean by these statements we need to have a fundamental understanding of how financial instruments such as mortgage bonds, corporate bonds, treasury bonds, commodities, futures, options, and stocks trade in a free market.



The Personality of Mortgage Bonds
First, there are a tremendous number of possible factors or variables involved in why any particular bond or stock trades the way it does. Some of these variables include fundamental analysis or evaluation, economic news, financial news, trader psychology, technical analysis and technical indicators to name a few. Another point to consider is each individual entity traded, such as a particular stock or bond, can exhibit its own “market personality” by trading in response to or because of a combination of some of the variables just mentioned. There is even an interesting theory called “The Personality of Markets Theory” developed by Ed Downs of Nirvana Systems that states individual securities exhibit individual personalities and if you can pinpoint a security's personality, and apply the right trading system for that personality, you can predict its next move and make money.
So, what causes these different personalities to develop? Price moves occur because of what people do and, human nature says people tend to be rather predictable. Furthermore, the same people make up a large portion of the market. So, the traders who liked a mortgage bond or stock last week and are selling it this week, will probably like it again next week. Again, human nature says that once you've traded a security and either made a good move, or missed a move, you will look for another opportunity to try again. Also, different types of people are attracted to different types of securities.
Technical analysis is the art of measuring these repeating patterns of human behavior in order to predict future behavior and the resulting price action. By looking at the past behavior of the market, traders have observed certain patterns and created trading systems based on those patterns. You can use these systems to predict what will happen next in the market or in a particular security. The problem is that there have been hundreds of trading systems developed; all of which work well as long as the market is exhibiting the personality for which the system was designed.
The trading system we’ve been successfully using with mortgage bonds is the Japanese Candlestick method of trading. Japanese Candlesticks capture the psychology and personality of the mortgage bond market. Candlesticks have also been remarkably accurate for us in signaling reversals in direction and predicting moves in mortgage bond prices.
The personality of the mortgage bond market can change from time to time. It can occasionally be volatile but most often it is either trending or in a trading range. While trending or within a trading range, we look for resistance and support levels to help define the risks of locking or floating at a given point in time. There are a number of ways to determine resistance (where selling pressure occurs) and support (where buying pressure occurs) levels for different periods of time. Usually, resistance and support levels can be charted on a short-term (1-16 days), medium-term (17-32 days), or long-term (33-64 days) daily basis. Previous intra-day highs and lows within these time intervals can serve as resistance and support levels. Moving averages can also serve as resistance and support levels. For short-term levels, 10-day increments can be used. For example the 10, 20, 25, 30, 40, and 50-day moving averages are typically used to help define possible resistance and support levels. Another effective method for determining resistance and support levels is through the use of Fibonacci Retracement. Please use the following link to access a separate article on Fibonacci numbers and Retracement:
For the mortgage bond analysis in the Mortgage Market Guide, we make use of all of these methods to help us identify resistance and support levels. We keep a close watch on these levels as the bond price approaches them because it is at these levels where reversals in direction most often occur.
The Risks of Locking and Floating
Now, let’s take another look at our recent statement “The risks of locking stand at about 19bp in lender price (points, not rate) to the first resistance level of $100.28.” By this statement we are saying with a current bond price of $100.09 ($100.28 – $0.19 = $100.09) there is a “risk” of locking at the current price if the price continues to trend or move higher up to the next resistance level we have identified at 19 basis points higher at $100.28. The risk is losing out on a potential 19 basis point move higher in price. There is no guarantee this will happen but if we have a bullish candle pattern showing coupled with a weak stock market, the prediction would be for an improvement in bond price to test the resistance level at $100.28.
Our companion statement was “The risk of floating is approximately 9bp to the first support level of $100, 31bp to the next support level at $99.69, and 81bp to our third level of support at 99.19.” Here we have identified three levels of support below the current price of $100.09. The “risk” of floating rather than locking at the current price if the price moves lower toward these support levels becomes 9 basis points to the first level of support at $100, 31 basis points to the next lower support level at $99.69, and 81 basis points to the third lower support level at $99.19. The bond may move lower to test one or more of these support levels if we have a scenario of a bearish candle pattern showing coupled with a stock market rally.
In summary, the mortgage bond analysis in the Mortgage Market Guide makes use of the Japanese Candlestick system of trading because we feel this best captures the personality of the mortgage bond market. Within this system, we identify resistance and support levels for you using several different methods and watch for signs of price reversal or change in the direction of trend. Based on these resistance and support levels, we then calculate the “risks” associated with either locking or floating at the current price level. The technical analysis of mortgage bonds provides you with another tool to assist with making timely and effective decisions to “lock” or “float” loans. We feel the analysis in the Mortgage Market Guide gives you a decisive edge over competitors and allows you to demonstrate a greater level of expertise to your clients.