What is a Delivery Option
A delivery option is a feature added to some interest rate futures contracts. The delivery option permits the option seller to determine the timing, location, quantity, quality, and the wildcard features of the underlying commodity which is set to be delivered. Delivery option terms are stated in the delivery notice.
BREAKING DOWN Delivery Option
Interest rate future options frequently contain delivery options. Delivery options make future contracts complicated, and traders need to understand all components of the deal entirely. All futures contracts are between a seller, known as the short, and the buyer, known as the long. The delivery option outlines a variety of methods for the seller to deliver the underlying security. The buyer may assume additional risk due to the seller's flexibility on delivery.
The Chicago Mercantile Exchange (CME) acts to assign a clearing firm to the futures contract traded on the Chicago Board of Trade (CBOT). Treasury bond future options are the most actively traded contract in the United States. The majority of exchange-traded options are American-style. An American option allows exercise anytime during its life. American options allow option holders to exercise the option at any time before and including its maturity date. In contrast, European options allow exercise only at maturity.
Elements of Delivery Options
At agreed upon points, during the futures contract, the seller may make decisions which will affect the delivery upon expiration. The CME provides information on the basics of Treasury futures Delivery options, basis spreads, and delivery tails.
- American-style options may contain the timing of delivery or the carry option. In this feature, the short may decide the time of surrender as long as it falls within the contract period terms. At times the seller may wish to retain the securities for coupon payment if there is a positive carry.
- The quality option is a type of rainbow option which allows the seller to deliver any Treasury bond with at least 15 years to maturity or call date. The seller will pick a bond with the lowest coupon rate available. This feature is known as cheapest to deliver (CTD) which allows delivery of the cheapest security to the long position to satisfy the contract specifications.
- The accrued interest option gives the seller the right to deliver the bond on any business day of the delivery month, which means they can track short-term interest rates over the course of the month to yield the best deal.
- The wildcard option grants sellers the right to deliver the bond up until 8 pm Chicago time on the final delivery day. That could be significant because the price sets at the close of trading, 2 pm, and the spot market trading continues trading until 8 pm, meaning the seller could take advantage of spot market trading shifts.
- With the end-of-month option, the seller has flexibility in determining the most advantageous sale day. That’s because the settlement day for contracts is the 8th-to-last business day of the month. With that price locked in, the seller with an end-of-month option has seven more business days to determine if prices are moving up or down. During the end-of-month period, the futures contract will not respond to market price changes.