What Is a Wild Card Option?
A wild card option is a type of option that is embedded in certain Treasury securities. It permits the seller of a Treasury bond to postpone delivery of its underlying asset until after regular trading hours.
This option benefits the seller because it allows them to benefit from a few hours’ extra time in which to secure a favorable price before settling their futures contract.
- The term “wild card option” refers to a right held by the seller of a Treasury bond futures contract.
- It permits the seller to wait until after-hours trading before delivering its bonds to the futures contract buyer.
- This can occasionally lead to a more favorable price for the seller, lowering the cost of their short position and thereby increasing their profits.
How Wild Card Options Work
U.S. Treasury bond futures contracts have been traded on the Chicago Board of Trade (CBOT) commodity exchange since 1977. Under the rules of the CBOT, trading in the Treasury futures market is terminated at 2:00 pm, but traders that have sold Treasury futures are not required to settle their contracts until 8:00 pm.
The amount that the short seller must pay in order to compensate the holder of the futures contract—known as the contract’s invoice price—is set as of 2:00pm. Because of the wild card option, however, Treasury futures sellers have the option of waiting for up to six hours, during which time they might benefit from favorable price movements during after-hours trading.
When exercising the wild card option, the seller of the Treasury futures contract would wait to see whether the spot price declines below the invoice price during after hours trading. If it does, then the seller could exercise their wild card option and make their delivery based on the low spot price, decreasing the overall cost of their short position.
Real World Example of a Wild Card Option
Treasury bond futures contracts are among the most actively traded investment securities in the world. To illustrate how a wild card option works in practice, consider the case of ABC Capital, a hypothetical investment firm that has taken a short position in the Treasury market by selling Treasury bond futures contracts. As the seller of the Treasury bonds, ABC Capital is obligated to deliver a specified quantity of Treasury bonds to the buyer, at a predetermined time. Once the settlement date is reached, however, ABC Capital can opt to use the wild card option embedded in its futures contract.
On the settlement date, ABC Capital can therefore wait for up to 6 hours following the end of the trading day before announcing its intention to deliver the bonds. During those 6 hours, the market price of bonds during after-hours trading might sink, giving ABC Capital the chance to purchase bonds at a more favorable price before rendering them to the buyer. This in turn would lower the cost of ABC Capital’s short position, thereby increasing their profit or reducing their loss.