Yield-based options
Yield-based options are based on changing bond yields in the Treasury (U.S. Government) debt market. For example:
Long 1 Jul TYX 35 call @ $4
The TYX is the 30-year Treasury Bond yield, typically the only yield index tested on the exam. An investor that is long the TYX is expecting bond yields to rise. In this scenario, the investor’s call goes “in the money” (gains intrinsic value) when the yield for 30-year Treasuries rises above 3.5%.
You’ve probably noticed a theme throughout the non-equity option chapter. Non-equity options are similar to standard equity options except for a few unique aspects. This is also true with yield-based options.
The strike price is the primary unique aspect of yield-based options. You must place a decimal between the first and second numbers to find the actual strike price (which references yield). That is why a long TYX 35 call is a bet that 30-year Treasury yields will rise above 3.5%. Beyond the strike price, all other characteristics of yield-based options are the same as standard equity options.
An investor goes long 1 Jul TYX 35 call at $4. Answer the following questions:
- Maximum gain
- Maximum loss
- Breakeven
- Gain or loss at a yield of 4.0%
- Gain or loss at a yield of 3.0%
- Maximum gain = unlimited
Long calls always maintain unlimited gain potential. The further the yields for 30-year Treasury bonds rise above 3.5%, the more the contract goes “in the money” (gains intrinsic value), and the more the investor gains.
- Maximum loss = $400 (premium)
If 30-year Treasury bond yields stay below 3.5%, the option is “out of the money” and will expire worthless. The worst-case scenario for an option holder is to lose the premium. A $4 option premium equals $400 overall ($4 x 100 multiple).
- Breakeven = 3.9% yield (strike + premium)
If the 30-year Treasury bond yield rises to 39 (3.9%), the contract is “in the money” by 4. When the investor exercises the option, the writer must deliver $400 (4 x 100) to the investor, offsetting the $400 premium paid upfront.
- Gain or loss at 40 (4.0%) = $100 gain
At 40 (4.0%), the contract is “in the money” by 5. When the investor exercises the option, the writer must deliver $500 (5 x 100) to the investor. When the initial premium paid ($400) is subtracted from the profit made at exercise ($500), the investor is left with a $100 gain.
- Gain or loss at 30 (3.0%) = $400 loss
At 30 (3.0%), the call is “out of the money” by 5 and will expire worthless. The investor paid a $400 premium for an option never utilized, representing their overall loss.
Yield-based options are commonly utilized by investors with significant investments in debt securities (especially long-term bonds). Fixed income securities (e.g., debt securities) lose value when interest rates/yields rise, which is known as interest rate risk. Longer-term bonds, especially those approaching 20-30+ year maturities, are especially exposed to this risk.
Let’s see if you can answer the next question:
An investor with an extensive bond portfolio is concerned about interest rate risk and wants to utilize yield-based options to hedge herself. Which of the following options should you recommend?
A) Long TYX calls
B) Short TYX calls
C) Long TYX puts
D) Short TYX puts
Answer: A) Long TYX calls
First, eliminate the short options as answers. Long options are almost always the better choice when identifying a hedging position. Best case scenario, writing (going short) options results in a gain equal to the premium (nothing more). If the investor’s portfolio faces significant risk, the premium will only offset that risk on a limited basis.
The investor is concerned about interest rate risk, which occurs when interest rates rise, forcing bond market prices downward. Her portfolio will experience losses if this happens.
The investor should purchase the option that will profit in case interest rates rise. Interest rates and yields are correlated, meaning they go in the same direction. When interest rates rise, so do yields (because bond prices are falling). Therefore, she should invest in the bullish long TYX call yield-based option.
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