Strategies

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Interest Rate Option Strategies

For the sake of simplicity, taxes, commissions and other trading costs have been omitted from the discussions and strategies in this discussion; these should be taken into account when making your investment decisions. The strategies are based on hypothetical situations and should only be considered as examples of potential trading approaches.



Investor Expects Rising 30-year Interest Rates

Strategy I - Buy TYX calls to profit from rising rates.

Forecast: Rising 30-year Treasury bond yields.

Objective: To profit from rising 30-year interest rates.

Strategy: Buy TYX calls.

If an investor anticipates a rise in the 30-year Treasury bond yield, he might choose to buy TYX call options. If the anticipated rate increase occurs, TYX, the 30-year underlying value for the options (10 times 30-year yield), also will increase.

This strategy gives the buyer the right to a payoff equal to the difference between the strike price and settlement value of TYX upon option expiration if the underlying value rises above the strike price. The profit is unlimited, while the risk is limited to the premium paid for the calls.

Example:
TYX is at 62.50 (the 30-year interest rate at 6.25%) and a three-month TYX 62.50 at-the-money call is trading at 1.50. For this example, the investor who expects 30-year Treasury yields to rise will buy 5 calls at a cost of $750 (1.50 premium x $100 multiplier x 5 contracts). A profit will be realized if the underlying rises above the breakeven of 64 (62.50 strike price + 1.50 premium) which translates into a current yield of 6.4% (.10 of the underlying value) on the 30-year Treasury.

Settlement Value Above Breakeven(64):
If the 30-year Treasury bond yields do rise and the settlement value for TYX is at 67.50 at expiration (interest rates at 6.75%), the TYX 62.50 call option would be exercised, the holder of the calls would receive the amount by which the closing yield exceeds the strike price.

  • Settlement Value: 67.50
  • Less Strike Price: 62.50
  • Difference: 5
  • Amount Paid to Holder (5 x $100 x 5 contracts): $2,500
  • Less Cost of Calls:-750
  • Profit: $1,750

This investor profited because the yield did rise above the breakeven prior to expiration. Had the yield on the 30-year Treasury risen after expiration the options would have expired worthless. This concept applies to all of the strategies discussed below.

Settlement Value Between Call Strike Price (62.50) and Breakeven Level (64):
If by expiration the 30-year Treasury yields do slightly increase to 6.35% which equals a settlement value of 63.5, the holder would exercise his options. He would receive the amount by which the settlement value is above the strike price. The amount received would be less than what was originally paid, but it would offset some of the cost of the calls.

  • Settlement Value: 63.50
  • Less Strike Price: 62.50
  • Difference:1
  • Cost of Calls: $750
  • Less Amount Paid to Holder(1 x $100 x 5 contracts):-500
  • Loss: $250

Settlement Value At or Below Call Strike Price (62.50):
If the settlement value is at or below 62.50 (the yield on the 30-year Treasury at or below 6.25%), the holder would have lost the total premium of $750, in this example. However, no matter how low interest rates decline the most that can be lost is the premium paid.

Importantly, if the yield on the Treasury rises substantially and/or the investor's opinion changes, the calls may be sold at any point in time through the last trading day of that particular series.