What Are Yield-Based Options?
Let me explain what a yield-based option is. It's a type of financial contract that lets you, as an investor, buy or sell calls and puts based on the yield of a security instead of its price. This means you're essentially betting on interest rate changes through the yield.
Key Takeaways on Yield-Based Options
You need to remember that these options allow trading calls and puts on yields rather than prices. The contract gives you the right, but not the obligation, to buy or sell at an underlying value that's 10 times the yield. They're great for hedging your portfolio and making profits when interest rates are rising. Sometimes, you might find it simpler to get similar benefits by using options on ETFs instead.
Understanding Yield-Based Options
A yield-based option is straightforward: it's a contract where you get the right, but not the obligation, to purchase or sell at a value equal to 10 times the yield of the underlying security. Yields are percentages, so for these options, the underlying is multiplied by 10. For instance, if a Treasury bond yields 1.6%, the option's underlying value is 16. These are cash-settled, often called interest rate options.
If you're buying a yield-based call, you're expecting interest rates to increase, while a put buyer anticipates a decrease. Say the interest rate on the underlying security goes above the strike for a call— that's when it's in the money. For puts, it's in the money if rates drop below the strike. But don't forget, you have to pay premiums, and as yields rise, call premiums go up while puts lose value.
These are European options, so you can only exercise them on the expiration date, unlike American options that you can exercise anytime before expiration. Since they're cash-settled, if you exercise, the writer just pays you the cash difference between the actual yield and the strike yield.
Types of Yield-Based Options
Some of the most common yield-based options track the yields of the latest 13-week Treasury bills, five-year Treasury notes, 10-year Treasury notes, and 30-year Treasury bonds. Options on 13-week T-bill yields, known as IRX, give you the most direct way to profit from interest rate shifts. On the other hand, options on five-year (FVX), 10-year (TNX), and 30-year (TYX) Treasury yields tend to react less to short-term rate changes.
Benefits of Yield-Based Options
Yield-based options are particularly useful if you're looking to hedge your portfolio or profit in a rising interest rate environment. They're one of the few tools that let you make money when rates go up, and here's why that matters. Periodically, the Federal Reserve starts increasing rates to curb inflation from speculation in stocks or commodities. As rates rise, safe money market returns improve, making risky assets like stocks, commodities, and bonds less appealing, which leads to selling and price drops.
Think about years like 1981, 1994, or more recently 2018, when the Fed hiked rates multiple times. In those periods, most assets lose value, but yield-based calls, especially on 13-week T-bill yields, can turn a profit. Importantly, you can't replicate these hedging benefits with regular stocks or bonds.
Disadvantages of Yield-Based Options
That said, there are alternatives to yield-based options that might suit you better. Many investors are more familiar with options on exchange-traded funds (ETFs), and buying a put on a long-term Treasury ETF can also let you profit from rising rates. Yield-based options have the same time-decay issue as other options—if rates don't move for years, you'll lose money on them.
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