What Is Yield-Based Option?

A yield-based option allows investors to buy or sell calls and puts on the yield of a security rather than its price.

Understanding Yield-Based Options

A yield-based option is a contract that gives the buyer the right, but not the obligation, to purchase or sell at the underlying value, which is equal to 10 times the yield.

Yields are expressed as percentage rates, and the underlying values for these options contracts are 10 times their yields. For example, a Treasury bond with a yield of 1.6% would have a yield-based option with an underlying value of 16. Yield-based options are settled in cash, and they are also called interest rate options.

A yield-based call buyer expects interest rates to go up, while a yield-based put buyer expects interest rates to go down. Suppose the interest rate of the underlying debt security rises above the strike rate of a yield-based call option. In that case, the call is in the money. For a yield-based put, the option is in the money when the interest rate falls below the strike rate. However, yield-based option buyers must also pay option premiums. When yields increase, yield-based call premiums increase and yield-based put options will lose value.

Yield-based options are European options, which means that they can only be exercised on the expiration date. On the other hand, American options can be exercised any time up to the contract's expiration date.

Given that these options are cash-settled, the writer of the call will simply deliver cash to the buyer that exercises the rights provided by the option. The cash amount paid is the difference between the actual yield and the strike yield.

Types of Yield-Based Options

Some of the best-known yield-based options follow the yields of the most recently issued 13-week Treasury bills, five-year Treasury notes, 10-year Treasury notes, and 30-year Treasury bonds.

• Yield-based options on 13-week T-bill yields (IRX) are the most direct way to profit from interest rate changes.
• Yield-based options on five-year Treasury yields (FVX), 10-year Treasury yields (TNX), and 30-year Treasury yields (TYX) are generally less responsive to short-term interest rate changes.

Benefits of Yield-Based Options

Yield-based options are extremely useful for hedging portfolios and profiting in a rising interest rate environment. Yield-based options are one of the few ways to make money when interest rates go up, and we will see why.

From time to time, the Federal Reserve embarks on a campaign of sustained interest rate increases. That usually happens because the Fed wants to reduce unsustainable price increases driven by speculation in the stock market or commodities markets. As interest rates go up, investors can get more without taking any risk in the money market. That makes the risks of stocks, commodities, and even bonds less attractive. As investors sell risk assets, their prices decline, which also decreases speculation.

There were several notable years when the Fed repeatedly hiked rates. 1981 and 1994 are perhaps the most famous, and 2018 is a more recent example.

In a rising rate environment, it is challenging to find any asset with an increasing price. However, yield-based calls, especially on 13-week T-bill yields, are likely to be profitable.

Disadvantages of Yield-Based Options

There are other ways to get the benefits of yield-based options. Yield-based options are certainly less familiar to many investors than options on exchange-traded funds (ETFs). Buying a put on a long-term Treasury ETF is another way to profit when interest rates go up.

Yield-based options also suffer from time-decay, just like most other options. If interest rates stay in place, which they can do for years, buyers of yield-based options will lose money.