What are yield-based options?
Yield-based options allow investors to buy or sell a call and put a security’s yield instead of its price.
- Yield-based options allow investors to buy or sell a call and put a security’s yield instead of its price.
- A yield-based option is a contract that gives the buyer the right, but no obligation, to buy or sell an underlying value equal to 10 times the yield.
- Yield-based options are useful for hedging portfolios and profiting in an environment of rising interest rates.
- Some of the benefits of yield-based options may be more readily available by purchasing ETF options.
Learn about revenue-based options
A yield-based option is a contract that gives the buyer the right, but no obligation, to buy or sell an underlying value equal to 10 times the yield.
The yield is expressed as a percentage, and the underlying value of these options contracts is 10 times their yield. For example, a Treasury note yielding 1.6% would have a yield-based option with a base value of 16. Yield-based options are cash-settled and are also known as interest rate options.
Buyers of yield-based calls expect rates to rise, while buyers of yield-based puts expect rates to fall. It is assumed that the interest rate on the underlying debt security is higher than the strike rate of the yield-based call option. In this case, the phone is rich. For yield-based put options, when the interest rate is lower than the strike rate, the option is in the money. However, buyers of yield-based options must also pay an option premium. When the yield increases, the yield-based call premium increases and the yield-based put loses value.
Yield-based options are European-style options, which means they can only be exercised on the expiration date. American-style options, on the other hand, can be exercised any time before the contract expiration date.
Given that these options are cash-settled, the writer of the call option will simply deliver cash to the buyer exercising the rights offered by the option. The cash amount paid is the difference between the actual yield and the exercise yield.
Yield-Based Option Types
Some of the most well-known yield-based options follow the yields on the recently issued 13-week, 5-year, 10-year, and 30-year Treasury bills.
Benefits of Yield-Based Options
Yield-based options are useful for hedging portfolios and profiting in an environment of rising interest rates. Yield-based options are one of the few ways to make money when interest rates rise, and we’ll see why.
From time to time, the Fed has launched a campaign to keep raising interest rates. This is usually because the Fed wants to reduce unsustainable price increases driven by speculation in the stock market or commodity markets. As interest rates rise, investors can earn more without taking any currency market risk. That makes stocks, commodities and even bonds less attractive. As investors dumped risk assets, their prices fell, which also reduced speculation.
The few years the Fed has hiked rates several times are noteworthy. 1981 and 1994 are probably the most famous, with 2018 being the most recent example.
In an environment of rising interest rates, it’s hard to find any asset whose price has risen. However, yield-based call options, especially 13-week Treasury yields, are likely to be profitable.
It is impossible to obtain the hedging benefits of yield-based options from traditional assets such as stocks and bonds.
Disadvantages of Yield-Based Options
There are other ways to get the benefits of yield-based options. Compared to options on exchange-traded funds (ETFs), many investors are certainly less familiar with yield-based options. Buying put options on long-term Treasury bond ETFs is another way to profit when interest rates rise.
Like most other options, yield-based options are subject to time decay. If interest rates stay the same, they can do so for years, and buyers of yield-based options will lose money.