Strategies

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 Falling 5-year Interest Rates

Strategy II - Sell FVX call spread to profit from declining rates.

Forecast: Investor Expects Falling 5-year Treasury note yields.

Objective: To profit from a decline in 5-year interest rates.

Example:
For simplicity's sake the investor will sell 1 three-month FVX 40 call and buy 1 three-month 45 call. The premium received for this spread position is;

• Sell 1 three-month 40 call at 5-.375 x 100=\$537.50
• Buy 1 three-month 45 call at 1-.375 x 100 = -137.50

• Long Strike: 45
• Short Strike: -40
• Difference: 5
• Maximum Risk: 1

The maximum risk is 1 x \$100 or \$100 for this position. The breakeven on this position is the 44 (40 short strike + 4 premium received).

Settlement Value At or Below Short Call Strike (40):
If 5-year Treasury bond yields do decline and the settlement value for FVX is at 39.50 at expiration (interest rates at 3.95%), the FVX 40 and 45 call would both expire worthless and the investor keeps the total premium received, \$400. This is the maximum profit that could be earned.

Settlement Value Between Short Call Strike Price (40) and Breakeven (44):
If by expiration the 5-year Treasury yields do decrease to 4.1% which equals a settlement value of 41, the spread seller would be assigned on his short call position. His long position would expire worthless. He would deliver the amount by which the settlement value is above the strike price. The seller of the spread would give up some of the premium received but not all of it.

• Settlement Value: 41
• Less Short Strike Price: -40
• Less Amount to Deliver(1 x \$100 x 1 contract): -100
• Profit: \$300

Settlement Value Between Breakeven (44) and Long Call Strike (45):If at expiration, the yield on the FVX is 4.45% or the settlement value is 44.50, the spread seller will be assigned on the short side. The seller would have to deliver more than the \$400 originally received but would not be paying the maximum risk of \$100.

• Settlement Value: 44.50
• Less Short Strike Price: -40
• Amount to Deliver: 4.50
• Amount to Deliver(4.50 x \$100 x 1 call): \$450
• Loss: \$ 50

Settlement Value At or Above Long Call Strike Price (45):
If the settlement value is at 46, the yield on the 5-year Treasury is at 4.6%, the holder would have lost 1, the difference between the strikes (5) less the premium received for selling the spread (4). However, no matter how high interest rates rise the most that can be lost is \$100, the difference between the strikes less the premium received.

• Settlement Value: 46
• Less Long Strike Price: -45