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Profit from Interest Rate Options
Options traders take interest rates into consideration when trading options on stocks, commodities, and foreign exchange. However, it is possible to profit from interest rate options directly as well. Interest rate options are traded on the Chicago Board Options Exchange, CBOE. Options traders can purchase both puts and calls on the spot yield of US Treasury securities. These are traded like European stock options in that they can only be exercised upon expiration of the contract. Nevertheless, options traders can open and close call or put positions throughout the duration of the contract period. Traders who expect interest rates to raise purchase calls and traders who expect interest rates to fall purchase puts. If you choose correctly and profit from interest rate options you receive a cash settlement.
Contracts, like stock options, have a 10 times multiplier times the interest rate yield of the 13 week, 5 year, 10 year, and 30 year US Treasury yield. As with stock options traders purchase options contracts in lots of 100. A 5.7% 10 year US Treasury yield converts to $57 and one purchases calls or puts on 100 contracts which are valued at $5,700. If the 10 year US Treasury rate rises to 6% the 100 contract value rises to $6,000. The call contract profit from interest rate options in this case is $6,000 - $5,700 = $300 minus the cost of the call contract.
If you are going to profit from interest rate options you need to do two things. You need to correctly assess the direction in which interest rates will go. And you need to do so in such a way that the return on your call or put contract is less than the price that you pay for the contract. So, what determines the contract price in interest rate options? Expectation of future value is the answer. If the market expects interest rates to raise it will price call contracts accordingly. If there is very little time remaining before expiration the price of a put or call will essentially be the difference between the strike price and the spot price. The longer there is before expiration of the contract the large is the effect of market sentiment as to future rates. As with trading stock options one can buy calls to lock in opportunity. In this case it would be because the trader expects interest rates to rise.
What Interest Rates Are Traded and Why?
The CBOE offers interest rates options on 13 week Treasuries, 5 Year Treasury Notes, Ten Year notes, and the Thirty Year Treasury Bond. The ticker symbols for these are IRX, FVX, TNX, and TYX. The worldwide market for exchange traded interest rate options is well in excess of $3 Trillion. Although many may choose to speculate in order to profit from interest rate options there are also many investors who will buy options to hedge risk that might be caused by interest rate fluctuation.