What is a Price-Based Option
A price-based option is a derivative financial instrument in which the underlying asset is a debt or debt-futures security. These options give their holders the right to purchase or sell an underlying bond or receive cash payment based on the market value of the underlying security.
Price-based options trade sparsely in modern financial markets and are unique. The yield-based option is a more commonly-traded relative of the priced-based option.
Breaking Down Price-Based Option
Priced-based options help investors and traders speculate on Treasury price movements or to hedge against a change in the prices of Treasury securities. As interest rates change, the prices of Treasury securities move in the opposite direction.
Investors who think interest rates will rise in the future typically buy price-based puts or sell price-based calls. Conversely, investors who think rates will fall sell price-based puts or buy price-based calls.
For example, a priced-based call option on a September 2018 10-year T-Note contract gives the buyer the right to assume a long position on it, 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 2018 10-year T-Note contract. The seller in this case must assume a long position.
Price-based options on Treasury notes and bonds rely on a $100,000 par amount of a specific Treasury note or bond. Price based options on Treasury bills are based on $1,000,000 par value.
Price-based options, when exercised, result in the delivery of a specific security.
Pros and Cons of Price-based Options
Within the category, options on treasury futures are one of the most popular. They are a liquid and transparent way to deal with exposure to interest rate and economic events. Within futures contracts, the 5-year note, 10-year note and 30-year bond are the most traded in the world. Of course, there also are options on cash bonds.
That said, yield-based options are more common than price-based options. A yield-based call buyer expects interest rates to go up, while a yield-based put buyer expects interest rates to go down. If the interest rate of the underlying debt security rises above the strike rate of a yield-based call option plus the option premium paid, the call holder is 'in the money'.
Should the opposite occur, and the interest rate falls below the strike rate yield less than the premium paid for a yield-based put option, the put holder is in the money. When yields increase, yield-based call premiums increase, and yield-based put options lose value and most likely expire.