Many governments discover their spending exceeds their revenues. As an alternative to unpopular tax hikes, they raise debt by selling government bonds, like U.S. Treasuries. Government bonds are considered risk-free because stable governments are not expected not to default on obligations. These debt instruments are more popular in times when stock markets look weak, encouraging skittish investors to seek safer options.
One factor that poses a risk to debt instruments is the interest rate. As a general rule, when the interest rate goes up, bond prices go down and vice versa. Options related to interest rate instruments like bonds are a convenient way for hedgers and speculators to deal with fluctuating interest rates. Within this category, options on Treasury futures are highly popular because they are liquid and transparent. Other than options on futures, there are options on cash bonds. (For related reading see Understanding Interest Rates, Inflation And The Bond Market.)
Options on Futures
Options contracts typically offer great flexibility as they offer the right (rather than obligation) to buy or sell the underlying instrument at a predetermined price and time. Upon entering an options contract, the option buyer pays a premium. The contract will specify the expiration date of the option and various conditions. For the option buyer, the premium amount is the maximum loss that the buyer will bear while the profit is theoretically unlimited. The case for the option writer (the person who sells the option) is very different. For the option seller, the maximum profit is limited to the premium received while loss can be unlimited.
In entering an options contract, the buyer is purchasing the right to buy (called a call option) or to sell (called a put option) the underlying futures contract. For example, a call option on September 10-year T-Note gives the buyer the right to assume a long position while the seller is obligated to take a short position if the buyer chooses to exercise the option. In the case of a put option, the buyer has the right to a short position in the September 10-year T-Note futures contract while the seller must assume a long position in the futures contract.
|Buy||The right to buy a futures contract at a specified price||The right to sell a futures contract at a specified price|
|Strategy||Bullish: Anticipating rising prices/falling rates||Bearish: Anticipating falling prices/rising rates|
|Sell||Obligation to sell a futures contract at a specified price||Obligation to buy a futures contract at a specified price|
|Strategy||Bearish: Anticipating rising prices/falling rates||Bearish: Anticipating falling prices/rising rates|
An option is said to be covered if the option writer (seller) holds an offsetting position in the underlying commodity or the futures contract. For example, a writer of a 10-year T-Note futures contract would be called covered if the seller either owns cash market T-Notes or is long on the 10-year T-Note futures contract. The seller’s risk in selling a covered call is limited as the obligation towards the buyer can be met either by the ownership of the futures position or the cash security tied to the underlying futures contract. In cases where the seller doesn’t possess any of these to fulfill the obligation, it is called an uncovered or naked position. This is riskier than a covered call.
While all terms of an option contract are predetermined or standardized, the premium which is paid by the buyer to the seller is determined competitively in the market place and in part depends on the strike price chosen. Options on a Treasury futures contract are available in many types and each option has a different premium according to the corresponding futures position. An option contract would typically specify the price at which the contract can be exercised along with the expiration month. The predefined price level selected for an option contract is called its strike price or exercise price.
The difference between the strike price of an option and the price at which its corresponding futures contract is trading is called the intrinsic value. A call option will have an intrinsic value when strike price is less than the current futures price. On the other hand, a put option has intrinsic value when strike price is greater than the current futures price.
An option is referred to as “at the money” when the strike price = price of the underlying futures contract. When the strike price is suggestive of a profitable trade (lower than market price for call option and more than market price for put option), that option is called “in-the-money” and is associated with a higher premium as such an option is worth exercising. If exercising an option means immediate loss, the option is called “out-of-the-money.”
An options premium is also dependent on its time value, that is, the possibility of any gain in intrinsic value before expiry. As a general rule, the greater the time value of an option, the higher the option premium will be. The time value decreases over time and decays as an option contract reaches expiration. (For related reading see 20-Year Treasury Bond ETF Trading Strategies.)
Options on Cash Bonds
The market for options on cash bonds is much smaller and less liquid than that for options on futures. Traders in cash bond options don’t have many convenient ways of hedging their positions and when they do, it comes at a higher cost. This has diverted many towards trading cash bond options over-the-counter (OTC) as such platforms cater to the specific needs of clients, especially institutional clients. All specifications like strike price, expirations and face value can be customized.
The Bottom Line
Among debt market derivatives, U.S. Treasury futures and options offer most liquid products. These products have wide market participation from around the globe through exchanges such as CME Globex. Options on debt instruments provide an effective way for investors to manage interest rate exposure and benefit from price volatility.