How Does the Interest Rate Impact Options Trading

Views 3394 Jul 9, 2024

There's a wide world of options products some investors can choose from to help meet their investment goals. One product that can help investors hedge their portfolio against interest rate changes is an interest rate option.

Interest rate options grant the holder the privilege, but not the obligation, to either pay or receive a designated interest rate on a set principal for a specified duration. Read on to learn more.

What is an interest rate option

An interest rate option is a financial derivative contract that gives the holder the right, but not the obligation, to buy or sell a debt instrument at a predetermined interest rate within a specified period. Interest rate options allow the holder to potentially benefit from changes in interest rates.

These options are typically based on underlying instruments such as Treasury bills, government bonds, or interest rate swaps and they can help banks, businesses, and some investors manage risk associated with abrupt rate jolts caused by central bank moves, or geopolitical shifts.

Interest rate options examples

Let's review some interest rate options examples.

First, an investor is speculating on rising interest rates and buys a call option on the 30-year Treasury bond with a $50 strike price, with an August 31 expiration date and $1.50 premium. If interest rates rise by the expiration date and the option is worth $58 at expiration, the investor could earn an $8 difference (or $800 based on a 100 multiplier). If the investor purchased one contract, the net profit could be $800 - $150 premium or $650 less fees.

Alternatively, if an investor believes interest rates will not significantly increase, they can sell a call option on the 30-year Treasury bond with the $50 strike price, August 31 expiration date and a $1.50 premium. They will collect $150 ($1.50 premium x100) less commission and fees.

If the interest rate remains stable or falls, the option is unlikely to be exercised, allowing the investor to profit from the premium collected. However, if interest rates rise above the strike price of the call option, the investor would be obligated to compensate the option holder for the difference, potentially offsetting the initial premium income with a loss.

Keep in mind that interest rate options are cash-settled, based on the difference between the exercise strike price and the exercise settlement value determined by the prevailing spot yield. These options usually have European-style exercises, meaning they can only be exercised at expiration.

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Types of interest rate options

Interest rate options come in various forms, each designed to manage risk associated with interest rate fluctuations differently. Common types include the following:

Interest rate caps: Sets an upper limit on the interest rate a borrower will pay. If interest rates rise above this cap, the issuer compensates the holder, helping to manage the cost of variable-rate debt.
Interest rate floors: Acts as the counterpart to caps by setting a minimum interest rate level. If rates fall below this minimum, the holder receives payment. This is beneficial for investors seeking to ensure a baseline return.
Interest rate collars: Involves simultaneously purchasing a cap and selling a floor (or vice versa), limiting exposure to interest rate movements within a specified range. This strategy offers a balance of protection and cost, allowing for more predictability in financial planning.
Swaptions: Gives the holder the right, but not the obligation, to enter into an interest rate swap under predetermined terms. Swaptions can be used to manage existing swap agreements or to speculate on future interest rate movements.

Call options

Similar to other options products, interest rate options have call and put options.

A call option gives the holder the right, but not the obligation, to potentially benefit from rising interest rates. If, at the expiry of the option, interest rates have risen and are trading at a rate higher than the strike price (the predetermined price), the investor holding the call option likely earns a profit.

For example, an investor has a call option on a 10-year U.S. Treasury bond with a strike rate of 2%. If the current market interest rate for a 10-year U.S. Treasury bond is 2.5%, then your call option is considered in-the-money.

If the current market interest rate is 3% and the strike rate is 3.5%, this would be considered out-of-the money. It has no intrinsic value; however, the option could have time value if there is some time left until its expiration, and there is a chance that the interest rate could rise above the strike rate.

Put options

A put option gives the holder the right, but not the obligation, to benefit from falling interest rates. If interest rates fall below the strike price and low enough to cover the premium paid for the option, it becomes profitable or “in-the-money.”

Here are some examples.

If the investor believes that interest rates will fall, they might purchase a put option with a strike price of $62 (corresponding to a 6.2% yield). The investor pays a $2 premium for this option. If the yield on the Treasury falls to 5.5% (option value of $55), the investor can exercise the put option, selling the Treasury at the strike price of $62, even though its market value is only $55. The investor's profit is the difference between the strike price and the market value, minus the premium paid.

If the option is out-of-the-money at expiration, the strike rate of the option is lower than the current market interest rate. For example, the strike rate is $62 but now the market value is $64. It wouldn't make sense to exercise the option but the investor may be better off selling the Treasury in the open market at the higher market rate rather than exercising the option to sell at the lower strike rate.

Understanding the information from interest rate options

Interest rate options can show several important pieces of information about market expectations and sentiment toward future interest rate movements. Here's a few.

Indicates the market's consensus on whether interest rates are expected to rise, fall, or remain stable. This is inferred from the pricing of call and put options. For example, if call options are more expensive, this suggests a market expectation of higher interest rates in the future.
Provides options pricing insights into the volatility of interest rates expected by the market. Higher premiums on interest rate options typically signal that traders anticipate greater volatility in interest rates.
Serves as a barometer for economic sentiment and financial market stability, helping participants make informed decisions in a varying interest rate environment.

How and why interest rates affect options

Interest rates have a fundamental impact on options pricing, primarily through their effect on the cost of carrying an investment. This relationship is largely due to the concept of the time value of money: money available today is worth more than the same amount in the future because of its potential earning capacity. With option pricing, higher interest rates generally increase the cost of holding a position, which in turn affects call and put option prices differently.

For call options, higher interest rates typically lead to higher premiums because the increased cost of carry makes purchasing the option more attractive than buying the underlying asset outright. With put options, they usually decrease in value as interest rates rise as the cost of carrying a short position becomes more expensive.

Hedging risk with interest rate options

Hedging risk with interest rate options (ir options) involves using financial instruments to help protect against fluctuations in interest rates that can affect the value of investments. Here's a few examples of using interest rate hedge.

Interest rate cap and interest rate floors (options that limit the interest rate movement)

Interest rate cap: Purchased by an investor to set a maximum interest rate level. If interest rates rise above this cap, the option pays out to the holder, offsetting the increased costs of interest payments.
Interest rate floor: Guarantees a minimum interest rate, providing a "safety net" for investors receiving interest payments, ensuring they do not fall below a certain level.

Interest rate options (derivatives that allow investors to hedge against interest rate changes)

Interest rate call options: Similar to regular call options but based on interest rates. A holder benefits if rates rise. This is useful for borrowers.
Interest rate put options: Similar to regular put options but based on interest rates. A holder benefits if rates fall. This is useful for lenders.

Employing these strategies allows investors and borrowers to help stabilize their financial outlook, providing a measure of predictability and security in the face of volatile interest rate movements.

Advantages and risks of interest rate options

Here are some potential advantages and risks of interest rate options.

Advantages

Risk management: Allows investors to hedge against changes in interest rates. Investors can use them to try to protect themselves from interest rate risk associated with assets including government bonds and money market securities.
Customization: Tailors interest options to help meet their specific needs by choosing strike prices and expiration dates that align with their investment goals.
Lower upfront cost: Genreally requires less capital upfront as compared to directly trading interest rate products. This makes them more accessible to a wider range of investors.
Speculative trading opportunities: Provides opportunities for speculation. Call options can allow investors to potentially profit from increasing interest rates while put options can enable them to potentially benefit from decreasing rates.

Risks

Potential loss of value: Can lose value if interest rates move unfavorably. If the option expires out-of-the money, the investor may lose their initial investment.
Lack of understanding: Trading interest rate options can be very risky, complex, and requires an understanding of how options are valued along with the effects of interest rates.
Margin structure risks: Poorly hedged positions in interest rate call options can lead to significant losses, especially if margin requirements are not managed properly.

Please note that counterparty risk is greater in derivatives that are often sold over the counter. Interest rate options fall in this category and with them, this means that the option buyer is dependent on the seller for the fulfillment of contractual obligations. If the seller defaults on an obligation, the option holder loses their investment.

How to trade options using Moomoo

Moomoo provides a user-friendly platform for trading options. Please note at this time moomoo does not support interest rate options trading. This general step-by-step guide below can help you get started trading options.

Step 1: Navigate to your Watchlist, then select a stock's "Detailed Quotes" page.