Trading Interest Rate Options
US Treasury yields are inching up as traders expect the Federal Reserve to cut back on its quantitative easing program as soon as next month. The Fed has been buying $85 Billion worth of US Treasuries a month which has kept interest rates low and helped US industry, the housing market, and the economy in general slowly move out of the worst recession in three quarters of a century. In anticipation of reduced Fed intervention there has been a large sell off of US Treasury and other bonds. Interest rates are up with the 10 year treasury pushing three percent. A rise in interest rates makes existing bonds less valuable as one can buy bonds at current rates and obtain a higher return on investment. Profitable options trading on bonds is possible in the over the counter market. However, a better approach is trading interest rate options on the CBOE.
Interest Rate Options Trading
CBOE describes interest rate options as “European-style, cash-settled options on the yield of U.S. Treasury securities.” This is one of the kinds of options trading that deals solely in projected interest rates. These options trade in U.S. Treasury bills with short, medium, and long term rates. Options trading terms are the same in trading interest rates as in other options trading. Interest rate option trading is referred to as trading in yield based options. In trading interest rates on U.S. Treasury bills the individual who buys a call option expects the prevailing interest rate to go up. The individual who buys a put expects the rate to go down. For the buyer of a call option to profit, the underlying interest rate must rise above the strike price by more than the premium paid. For the buyer of a put option to profit, the interest rate must drop below the strike price by at least the price of the premium. In addition, taxes and commissions will figure into the cost analysis for interest rate option trading. For using risk management in options trading the same types of combinations of puts and calls, buys and sells apply as throughout options trading. Traders can seek profit in trading interest rate options on the the thirteen week Treasury bill which trades under the symbol IRX, the five and ten year notes as FVX and TNX, and the thirty year bond as TYX. Options expiration dates for interest rate option trading at CBOE are the Saturday following the third Friday of the expiration month. The option value of interest rate options is ten times the yield of the underlying security. For example an interest rate of 3% on a 5 year bond makes the option worth $30. Interest rate options trading contracts are settled in cash.