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 Rising 30-year Interest Rates

Strategy II - Sell TYX put spread to profit in a rising market.

Forecast: Investor Expects Moderate Rise in 30-year Treasury Bond Yields.

Objective: To profit from an increase in rates by bringing in income.

Example:
Assume, as before that TYX is still at 62.50, and a rise in 30-year interest rates from 6.25% to 7.0% is anticipated in the next three months. For simplicity's sake the investor will sell 1 three-month TYX 67.50 put and purchase 1 three-month 62.50 put. The premium received for this spread position is:

• Sell 1 three-month 67.50 put at 4.875 x 100 = \$487.50*
• Buy 1 three-month 62.50 put at 1.25x 100 = -125.00

*These puts are trading at a discount to parity due to the European-style exercise (the options cannot be exercised until expiration).

• Short Strike: 67.50
• Long Strike:62.505
• Difference: 5
• Maximum Risk: 1-.375

The risk for this position is 1-.375 x 100 or \$137.50. The breakeven on this position is 63.875. The breakeven is calculated by subtracting the premium received, 3.625 from the short 67.50 strike price.

Settlement Value At or Above Short Put Strike Price (67.50):
If 30-year Treasury bond yields do rise and the settlement value for TYX is at 68.50 at expiration (interest rates at 6.85%), the TYX 62.50 put and the 67.50 put both expire worthless and the investor keeps the total premium received, \$362.50. This is the maximum profit that could be earned. This would be the result for any TYX settlement value at or above 67.50.

Settlement Value Between Short Put Strike Price (67.50) and Breakeven (63.875):
If by expiration the 30-year Treasury yields do increase to 6.7 which equals a settlement value of 67, the spread seller would be assigned on his short put position and his long position would expire worthless. He would deliver the amount by which the settlement value is below the strike price. The seller of the spread would give up some of the premium received but not all of it.

• Short Strike Price:67.50
• Less Settlement Value: -67
• Amount to Deliver:.50
• Amount Rec'd for Selling Spread: \$362.50
• Less Amount to Deliver (.50 x \$100 x 1 contract):-50.00
• Profit: \$312.50

Settlement Value Between Long Put Strike Price (62.50) and Breakeven (63.875):
If at expiration, the yield on the TYX is 6.3% (the settlement value is 63), the spread seller would be assigned on the short side. The seller would have to give back some of the premium received.

• Short Strike Price: 67.50
• Less Settlement Value:-63
• Amount to Deliver: 4.50
• Amount to Deliver(4.50 x \$100 x 1 put): \$450.00
• Loss: \$ 87.50

Settlement Value At or Below Long Put Strike Price (62.50):
If the settlement value is at 60 (the yield on the 30-year Treasury is at 6.0%), the spread seller would have lost 1-.375, the difference between the strikes (5) less the premium received for selling the spread (3.625). However, no matter how low interest rates decline the most that can be lost is \$137.50, the difference between the strikes less the premium received.

• Short Strike Price: 67.50
• Less Settlement Value: -60
• Amount to Deliver: 7.50
• Long Strike Price: 62.50
• Less Settlement Value: -60
• Amount Delivered: 7.50
• Net Delivered: 5

The spread seller would pay out \$750 (7.50 x \$100 x 1 put) for the assignment of his short put and would receive \$250 (2.50 x \$100 x 1 put) for exercising his long put for a net cost of \$500.

• Net Delivered (See Above): \$500
• Maximum Loss: \$137.50

As the settlement value declines below 62.50 the amount to be delivered will increase but so will the amount paid to the investor. The net amount will always be \$500, the difference between the two strikes. Therefore, the risk is limited to \$137.50, the difference between the strikes less the premium received for selling the put spread.