As we know, options on interest rate futures provide the right, but not the obligation, to buy or sell a specific number of futures contracts at a pre-determined price within a specified period of time.
We will now learn about some uses of these contracts:
Covered Call Writing
An investor holding T-bonds or T-notes whose concern is rising interest rates may wish to protect the value of an investment and also enhance the yield by selling calls. If the value of the investment decreases, the call will expire (worthless to the holder) and the option writer will keep the premium. The investment yield is enhanced is enhanced through receipt of premium. Alternatively, if the value of the T-notes increases, the option will be exercised and the writer will deliver their investment to the call option holder, producing a limited profit from the sale plus keeping the premium.
Hedging a Firm Commitment
A company expects to receive $5,000,000 on the sale of a asset which it wishes to invest in t-bonds. The company expects a decrease in interest rates before the money is received. The company purchases a T-bond futures call option, thereby fixing the maximum price to be paid for the futures contract. If rates do fall, the lower yield from investing the $5,000,000 can be offset by a gain on the futures contract.
Investors can buy puts to protect against downside risk of holding interest sensitive assets. For example, if interest rates decline so the yield on interest sensitive assets also declines , gains from the put options can make up for this shortfall.
Selling Naked Puts
To capture premium (i.e., generate revenue) during a market that is relatively stable or declining modestly. This, however, exposes the writer to huge losses if the market turns against them.
Relies on the premise that, given equal fluctuations, the price of long-term debt instruments will move more sharply than prices of intermediate-term debt; therefore, when prices are advancing, sell notes and but bonds and vice versa.
Benefits of Options on Futures Contracts
- A potentially large profit from a relatively small cash outlay (buyer).
- The buyer of an option knows in advance that the maximum loss that can be incurred is the price paid for the option, yet, upside potential is unlimited.
- An opportunity for writers of options to increase the income derived from their investments.
- The protection they offer against a possible decline in the market value of owned investments.
- Liquidity: Positions can be liquidated in the event of a change in the investor’s circumstances.
Downside of Options on Futures Contracts
- The premium is paid by the buyer up front and can be sizable.
- The writer has unlimited risk of loss.
- The seller of an option (if not covered) must post margin.