Insight into Debt Options: A Brief Guide

 

Most governments believe that their spending exceeds their income. As an alternative to unpopular tax increases, governments can raise money by selling government bonds, such as US government bonds. Government bonds are considered risk-free because the most stable governments are expected to not fail to meet these obligations. These debt instruments are more popular in times when stock markets look weak, while timid investors look for safer options. Another way to invest in debt instruments and government bonds is through derivatives, such as futures and options. (For related information, see Six largest bond risks.)

Debt options

Debt options

A factor that poses a risk for debt instruments is the interest rate in the economy. As a general rule, when interest rates rise, bond prices fall and vice versa. Options regarding interest rate instruments such as bonds are a convenient way for hedgers and speculators to deal with fluctuating interest rates. Within the category, options on treasury futures are one of the most popular because they are a liquid and transparent way to deal with exposure to interest rates and economic events. Within futures contracts, the 5-year note, 10-year note and 30-year bond are the most traded in the world. Unlike options on futures, there are options on cash bonds. (For more information about the interpretation of interest rates, inflation and the bond market, see.)

Options on futures

Options on futures

Option contracts generally offer great flexibility because it offers the right (instead of the obligation) to buy or sell the underlying instrument at a predetermined price and time. When entering into an option contract, the buyer of the option pays a premium. The contract specifies the expiration date of the option and various conditions. For the buyer of the option, the premium amount is the maximum loss that the buyer will bear while the profit is theoretically unlimited. The case for the writer of the option (the person who sells the option) is very different. For the seller of options, the maximum profit is limited to the premium received, while the loss can be unlimited.

When entering an option contract, the buyer buys the right to buy (called call option) or to sell the underlying futures contract (called put option). For example, a 10-year T-Note call option on 10 September 2015 gives the buyer the right to take a long position, while the seller is obliged to take a short position if the buyer chooses to exercise the option. In the case of a put option, the buyer is entitled to a short position in the 10-year T-Note futures contract of 10 September 2015, while in this case the seller must take a long position in the futures contract.

Call Move
Buy The right to purchase a futures contract for a specified price The right to sell a futures contract at a specified price
Strategy Bullish: Anticipating rising prices / falling prices bearish: anticipating falling prices / rising prices
to sell obligation to sell a futures contract at a specified price obligation to purchase a futures contract at a specific price
Strategy Bearish: anticipating rising prices / falling prices bearish: anticipating falling prices / rising prices

Table source: CBOT

An option would be covered if the writer (seller) option takes an offset position in the underlying commodity or futures contract. For example, a writer of a 10-year T-Note futures contract would be called covered if the seller owns T -Notes on the money market or long on the 10-year T-Note futures contract. The risk of the seller when selling a covered call is limited because the obligation to the buyer can be met by owning the futures position or by the cash security linked to the underlying futures contract. In cases where the seller does not have one of these to fulfill the obligation, he is referred to as an uncovered or naked position. This is more risky than a covered call.

Although all the terms and conditions of an option contract are predetermined or standardized, the premium paid by the buyer to the seller is determined competitively on the market and partly depends on the chosen exercise price. Options on treasury futures contracts are available in many types and each option has a different premium according to the corresponding futures position. An option contract would typically specify the price at which the contract can be exercised together with the expiration month. The predefined price level selected for an option contract is called the exercise price or exercise price. Below are the specifications of an option on 10-year US Treasury Note futures on the Chicago Board of Trade (CBOT):

Contract size: One CBOT 10-year US Treasury Note futures contract for a specified delivery month.

Expiration date: Unnamed 10-year Treasury Note futures options expire at 7:00 p.m. Chicago time on the last trading day.

Font size: 1/64 of a point ($ 15,625 / contract) rounded to the nearest cent / contract.

Contract months : The first three consecutive contract months (two serial due dates and a quarterly due date) plus the following four months in the quarterly cycle (March, June, September and December). There are always seven months available for trading. Serials will practice in the first near quarterly futures contract. Quarterly contracts will be used for forward contracts with the same delivery time.

Last trading day: Options ceased trading on the last Friday, which expires at least two business days, the last business day of the month that the option month exercises. Options ceased trading at the end of trading from the regular daytime open auction trading session for the corresponding 10-year US Treasury Note futures contract.

Trading hours: Open auction: 7:20 am – 2:00 pm, Chicago time, Monday – Friday, electronically: 6:02 pm – 4:00 pm, Chicago time, Sunday – Friday.

Ticker symbols: Open auction: TC for calls, TP for puts, Electronic: OZNC for calls, OZNP for puts.

Daily price limit: None.

Interval with strike prices: One point ($ 1, 000 / contract) to pay the current 10-year T-trend trend. If T-notes with a duration of 10 years are 92-00, the exercise prices can be set at 89, 90, 91, 92, 93, 94, 95, etc.

Exercise: The buyer of a futures option may use the option on any business day prior to the expiration date by sending a notification to the Board of Trade.m clearing service provider at 6 p.m. , Chicago time. Options that expire in cash are automatically exercised in a position unless specific instructions are given to the clearing service provider of the Board of Trade.

The difference between the exercise price of an option and the price at which the associated futures contract is traded is called the net asset value. A call option has an intrinsic value if the exercise price is lower than the current futures price. On the other hand, a put option has intrinsic value when the exercise price is greater than the current futures price.

An option is called “at the money” as the exercise price = price of the underlying futures contract. When the strike price indicates a profitable transaction (lower than the market price for call option and more than the market price for put option), that option is called “in-the-money” and is linked to a higher premium such as this option is worth practicing. If exercising an option means immediate loss, the option is called “out-of-the-money”. “

An option premium also depends on its time value, ie the possibility of gaining in net asset value before expiration. As a general rule, the greater the time value of an option, the higher the option surcharge. The time value decreases over time and expires when an option contract reaches the expiry date. (For related information, see the treasury portfolio’s 20-year ETF trading strategies.)

Options on liquid bonds

Options on liquid bonds

The market for options on cash bonds is much smaller and less liquid than that for options on futures. Cash bond options traders do not have many convenient ways to hedge their positions and if they do, they become more expensive. This has led many people to trade in bond options (OTC) without cash, as such platforms meet the specific needs of clients, especially institutional clients. All specifications such as exercise price, expirations and nominal value can be adjusted.

The bottom line

 

Among debt market derivatives, US Treasury futures and options are some of the most liquid products. These products have wide market participation from all over the world through exchanges such as CME Globex. Options on debt instruments offer investors an effective way to manage interest rate exposure and take advantage of price volatility.

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