Yield-Based Option

A yield-based option helps traders when buying and selling calls and puts based not on the price of the security, but on its yield.

What is a Yield-Based Option

By holding a contract called a yield-based option, the client is entitled (not to be confused with an obligation) to buy or sell at a base value which is equal to ten times the yield. The yield is expressed in percent, and the underlying cost of current option contracts is 10 times higher than the indicator of the yield. Thus, the underlying value of the yield-based option on a Treasury bond would be 25, since its yield is 2.5%. This type of option, also known as interest rate options, is payable in cash.

The expectation of a person, who buys a yield-based call option is associated with an increase in the interest rate, while a yield-based put option buyer expectation, on the contrary, is associated with a decrease in the interest rate. If the underlying rate of a debt security rate is higher than the yield-based call option strike rate, then the call is considered to be in the money. And if the interest rate is lower than the strike rate, a yield-based put option is considered to be in the money. The bonus paid by the buyer of the yield-based option is called option premium. As yields increase, yield-based call premiums also increase, but yield-based puts will fall in their value.

To understand, consider the following example. Assume that a particular debt security with a yield of 6.3% and an investor bought this yield-based call at $100 per contract.

The first scenario is called “in the money”. When the option expires, the yield on the debt is 6.5%. A yield-based call option allows the buyer to buy the debt before January 1st. The client may exercise an option to buy this debt with a yield of 6.3%, and immediately sell this debt, receiving a yield of 6.5%. In this regard, this option will be sold at a price of $200, and because the purchase of this investor was $100, the net profit from this transaction will be $100.

The second scenario is named “out of the money”. But If the option expires and the yield on the debt is 6.3% or even lower, then the contract will close out of the money. In fact, it will lose its value and the buyer of the option will lose 100% of his money, that is, $100 that he spent on buying this option.

Yield-based options are considered European, which implies strict execution on the expiration date and nothing else, while American options do not have such a rule, which allows them to be exercised also before the expiry date. As the yield-based option is payable in cash, the writer of the option delivers the cash to the buyer exercising the rights conferred by the option. The distinction between of actual and strike yields lies in the amount of money paid out.

Good points of Yield-Based Options

The main benefit of yield-based options is to hedge an investor's portfolio and make a profit in the face of rising interest rates. In addition, this type of option allows the investor to earn money.

With a certain periodicity, the Federal Reserve System pursues a policy of gradually raising interest rates. Most often this is due to the measures taken by the Fed to control inflation and price increases caused by speculating on the stock exchange and commodity market. As interest rates rise, a certain investor can get more with less risk. Accordingly, the risks of securities such as stocks, bonds, as well as the risks of commodities become less attractive. With the sale of risky assets, their prices feel a decline, which leads to a decrease in speculation.

History remembers a few examples when the Federal Reserve System raised rates. 1981 and 1994 are the most famous, and 2018 and 2022 are the most recent examples. When the interest rate rises, it is quite difficult to find any asset with a rising price. Nevertheless, this instrument is likely to be profitable, especially if this yield-based option is based on thirteen week treasury bill yield.

Financial instruments such as stocks and bonds do not provide the advantages of yield-based options hedging.

Bad points of Yield-Based Options

Options on exchange-traded funds (ETFs) are without a doubt more popular among investors compared to a yield-based option. An excellent way to profit in the environment of rising interest rates is considered to be the purchase of a put option on a lasting Treasury ETF.

Many investors prefer options on ETFs to options based on yield because it allows them to get more benefits in a shorter period of time. 

The problem of yield-based options, which often applies to other types of options, is time-decay. When interest rates remain at their current level and there is no movement either up or down, yield-based options buyers will simply lose their money.

Some popular examples of Yield-Based Options

This type of option follows the yields of 13-week Treasury bills, 5-year Treasury notes, 10-year Treasury notes, and 30-year Treasury bonds. Yield-based options on 5-year Treasury yields (FVX), 10-year Treasury yields (TNX), and 30-year Treasury yields (TYX) are usually less sensitive to short-term interest rate changes

Yield-based options on 13-week T-bill yields (IRX) are the most popular instruments to obtain profit from interest rate changes.