Interest Rate Options

Interest rate options can be used by investors to benefit from future changes in interest rates. They provide liquidity and flexibility while also serving as risk management across the US dollar yield curve, for example. Interestingly, the trading of interest rate derivatives in over-the-counter markets more than doubled between 2016 and 2019, demonstrating their popularity with investors.

This guide will cover everything you need to know about trading interest rate options, including what they are, how they work, advantages and disadvantages, plus working examples.

Below we list the top-rated brokers that offer retail options trading in 2023.

Interest Rate Options Explained

Interest rate options are financial derivatives that enable investors to benefit from changes in interest rates over time. Contracts are often made on different kinds of bonds, such as treasury securities. They also tend to be traded on exchanges like the CME Group or over the counter.

Importantly, interest rate options are different from other options, even though they work in largely the same way in that they rely on the current market rate of the underlying asset, have a strike price and an expiry date, and are subject to market volatility.

They are different because while other options depend on the underlying security itself, trading interest rate options depend on the actual rates.

How Interest Rate Options Work

Interest rate options tend to be used as a hedge during economic uncertainty. When the option is purchased, the holder can pay a fixed rate for a rate that will likely vary in the future.

Interest rate options are similar to equity options in that they have premiums attached to them, a fee that the investor must pay to enter into the contract. Also similar to equity options, there are two standard types of contract:

• Call options
• Put options

A call interest rate option gives the holder the right, but not the obligation, to capitalize on interest rates rising. Investors can make money if the interest rates are trading at a higher rate than the strike price at the time that the option is exercised. The rates also need to be high enough that the profit is greater than the premium that was paid for the option.

A put interest rate option, on the other hand, gives the holder the right, but not the obligation, to capitalize on interest rates falling. In this case, the option will be profitable if the option is exercised at a time when the interest rates are lower than the strike price.

The exercise style for interest rate options is European, meaning that the contract can only be exercised at the expiry, and not before, as with American options.

This text discusses the simplicity of using and trading interest rate options, while minimizing the risk of early exercise.

It is important to note that interest rate options are cash-settled, and the profit is determined by the difference between the strike price and the settlement value.

Strike Price

Unlike regular options, the strike price for interest rate options is not equivalent to the underlying security price at the point of exercise. Therefore, the value of the option must be determined in another way.

Typically, the value of an interest rate option is ten times the price of the underlying treasury yield. For example, if the underlying treasury yield is 7%, then the value of the option is $70. If the yield increases to 7.7%, the value of the option becomes $77, and so on.

Caps, Floors, & Collars

Caps, floors, and collars are risk management products used to hedge interest rate risks. They are composed of multiple options with the same strike rate set and operate at successive periods.

Caps set a maximum interest rate and are priced according to predicted future rates. The strike rate is typically set higher than the current interest rate, leading to a lower premium for the investor.

Floors set a minimum interest rate, and the strike rate is usually set below current market rates to reduce premium costs.

Interest rate collars combine a cap and a floor to set both maximum and minimum interest rates.

This is what happens when an investor buys a cap and sells a floor at a lower interest rate. They are a type of spread where one option is either partially or entirely financed by the selling of another option. Usually, interest rate collars are made up of a long cap and a short floor, where the income made from selling the floor is used to offset all or part of the cost of the cap. The issue with this is that if the interest rate drops below the floor, the collar will lose money to the extent that the interest rate has dropped below said floor.

Volatility

Volatility refers to the speed and size of movements in government bond yields or interest rates. Volatility is referenced by two terms: realized volatility and implied volatility. Realized volatility is the volatility that is actually observed in interest rate options, so the more that yields or interest rates move every day, the higher the realized volatility. Implied volatility refers to the expected fluctuation of market prices, and this has a big effect on how options are priced. Higher implied volatility means higher prices.

The volatility risk premium refers to the compensation paid to an options seller. This premium tends to equate to the difference between the implied and realized volatility of the option.

Example

Let’s look at an example to see how an interest rate option works…

You purchase an interest rate call option with a strike price of $40 and an expiry date of June 30th with an underlying benchmark of the 30-year US treasury and a premium of $1.

By June 30th, the yield has increased, and the option is now valued at $45.

This would leave your net gain as $4 ($45 – $40 – $1 = $4).

The premium must also be used in the equation to find out the total gain from the option.

Because the yield increased, the option was worth more, and therefore a profit was made.

However, if the yield had dropped by June 30th and the option was valued at $25, then the option would expire and would not retain any worth, otherwise known as being out-of-the-money.

In this case, the investor would lose the $1 premium and make no gain from the option.

Advantages

There are many ways in which interest rate options are useful to traders during times of economic uncertainty.

The key advantage is that an interest rate option allows the holder to pay a fixed interest rate at a time when the interest rate may vary.

Interest rate options can be used as a hedging tool to help protect from fluctuating interest rates, so when an offsetting position is purchased, it reduces or entirely eliminates the risk that may have been present.

Contracts can also help investors to diversify their portfolios.

Disadvantages

One of the drawbacks that some investors find with interest rate options is that they do not come with the opportunity of early exercise like American-type options.

This means that they are not as flexible, and investors are not able to take advantage when interest rates are more favorable.

There is an opportunity for offsetting the option by entering into another contract, which is a way to negate the contract but is not the same as exercising it.

Interest rate options are also risky in some circumstances.

They are more sensitive to market volatility than other trading tools, meaning that fluctuations can wipe out profits. Even if your interest rate option is in-the-money at one point during its lifetime, price fluctuations can change this since the strike price is so tightly connected to the underlying futures price.

Strategy

It is important to have a good understanding of the bond market if you are going to start investing in interest rate options. Ill-informed trading with limited understanding of how trades should be structured, or how options trading in general works, can lead investors to take on excessively risky trades. Importantly, many factors influence interest rates, including announcements from the federal reserve and similar authorities.

Delta Hedging

Delta hedging is where directionality is taken out of the option, locking in profits even as rates move. An option by itself is exposed to directionality because its value moves as rates do, and this directionality is known as the ‘delta’ of the option: the directional exposure the option has to interest rates.

Delta hedging is a trading strategy that takes away the ‘delta’ of the option, by purchasing an offsetting position that has the same amount of delta as the first option, but in the opposing direction.

When an option is delta hedged, it is then protected against the directional movement in interest rates, because any profit or loss that is brought about by the first option is offset by an equal profit or loss brought about by the opposing hedge.

Although delta hedging protects investors by offsetting profit and loss, traders can still profit from volatility during periods of significant movements.

When there is a significant change, the exposure can exceed the delta hedge, leading to a larger profit. The hedge locks in the profit.

Getting Started

To start trading interest rate options, find a broker who offers options trading. Keep your budget in mind since commissions and account charges vary. You may need a margin account, so check the rates and account requirements.

Once your account is live, you can enter orders using an option chain. These tools identify the underlying asset, expiration date, whether the option is a call or a put, and the strike price.

Stay Informed

Stay updated on interest rates and respective markets by reading books, PDFs, and watching informational videos. Many of these resources offer free PDF downloads, so you can access the information at no cost.

Know When To Trade

Interest rate options trading typically occurs during stock market hours, from 9:30 am to 4:00 pm EST. Monitoring market changes early in the day can give you a headstart.

Final Word On Trading Interest Rate Options

Interest rate options can help hedge against changes in interest rates while providing decent payouts. Before you begin, understand the ins and outs of the bond market and develop a sound understanding of yields, contract prices, and the factors that influence the rise and fall of interest rates.

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