Interest-Rate Options for Bond Bulls

Today we wrap up our discussion of ways to profit from a big decline in interest rates with a lesson on call options on futures.

As with last week's futures lesson, this is intended as an explanation of the concepts involved, not as an instructional guide. Interest-rate futures, and options on those futures, aren't like bonds, where you have to go pretty far afield to lose lots of money. They are leveraged derivatives with which it's fairly easy to lose everything you brought to the game. If you're going to get involved, you need more information on the possible financial and tax consequences than you'll find here.

(By the way, the final paragraph of last week's column was accidentally omitted. It's there now, so you might want to have a second look.)

Along with Treasury futures contracts, options on them are listed on the Chicago Board of Trade.

Options on futures are even more complicated than futures. But just as investing in futures requires a smaller outlay than investing in actual bonds, options on futures can be had for even less than futures. Last week I explained how it's possible to profit from the bond futures contract with as little as $2,700. By contrast, options on Treasury futures can be purchased for as little as $15.625, or 1/64 in price terms (1 point equals $1,000). The trick with options is making them pay off.

A call option is a right to buy the underlying asset at a specified strike price at any time before the option's expiration. For example, the December 115 call option on the Treasury futures contract is an option to buy the contract, which settled yesterday at 114 3/32, at 115, any time before Nov. 19, when the option expires. (Another kind of options, put options, are a right to sell at a specified strike price.)

The higher the strike price, the lower the price of the option. This is clear in yesterday's CBOT options settlement report. Higher strikes have lower prices since there's a smaller likelihood the underlying asset will ever reach the strike price, in which case the option will expire worthless. (And the buyer of the option is out whatever he paid for it.)

If, however, the underlying asset goes over the strike price, the option's value can rocket. The deeper "in the money" a call option gets, the faster its price rises. The holder of the option can either sell it for a profit or exercise it, buying the underlying asset at a below-market price.

Selecting Call Options

There are two key concepts involved in selecting call options.

The first is that the nearest options -- options on the most active futures contract -- are the most economical to buy and offer the greatest liquidity. They are the most economical to buy because the longer the time till expiration, the greater the likelihood that the underlying asset will reach the strike price during that period. Accordingly, faraway options sell for much higher prices.

The nearest options offer the greatest liquidity because that's where the greatest volume is, as the CBOT's daily volume report shows.

The second concept is that the higher a call option's strike price, the more rapidly its price will accelerate if it goes into the money. So as a general principle, you'd want to buy the highest strike price you feel certain will go into the money.

This concept is clearly illustrated by yesterday's price action. The December Treasury bond futures contract settled last night at 114 3/32, up 18/32 from Wednesday, the CBOT's futures settlement report shows. Accordingly, the options settlement report shows big increases in the prices of calls to buy the contract at strike prices under 114.

But you'll notice that the price increases in the December options are nearly identical for the strike prices from 90 to 111, even though the 111 strike's price is much lower than the 90's.

A boiled-down version of a common strategy is to buy the strike higher than the contract price by one quarter of the full amount you expect the contract to rise in a year. For example, if you are looking for a 10-point gain over the next year, you might buy the strike 2 1/2 points over the current price each quarter (less if there's less than a quarter to expiration, since some of the time you expect the move to take has passed).

Implied Volatility

Often, if not always, the strategy involves the implied volatility of the futures contract.

Implied volatility measures the likelihood of future price changes, and it's a function of how much investors are willing to pay for options. (An extremely complicated function, I might add.)

An implied volatility of 10 indicates a two-thirds probability that a year from now, an asset's price will fall in a range between 10% lower and 10% higher than its current price. The CBOT's site has a daily implied volatility report. The difference in the implied volatilities of the December and March contracts is explained by the fact that the December contract is closer to expiration. Over a shorter time period, the price is unlikely to fluctuate as much.

An options trader might look at the implied volatility of the Treasury futures (10.74 for the March contract as of yesterday) and decide it's reasonable to bet that the contract, which closed at 94 21/32 Thursday, will rise 10.74% over the next year. The trader might select quarterly strike prices based on that expectation, adjusting the strategy over the course of the year if the implied volatilities don't keep pace.

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