When buying an option, you buy the right to buy or sell a certain amount of securities in the future for a pre-determined price. For example, you make the agreement to have the right to purchase 100 shares in company X six months from now at a price of $7 a share.
Options are a type of derivative; this means that the product derives its value from the price of an underlying asset. The underlying asset can be an index, a share or even a commodity. In this article, we explain fixed income options. Read more about options in general in this article.
American-style options
Fixed income options are classified as American-style options. In contrast to European-style options that can only be exercised at expiry, they can typically be exercised at any time and usually result in long or short positions in the underlying fixed income future. Information about the underlying and the strike price of an option is included in the name of the option. The option’s symbol gives information about the underlying and the strike is also part of the name.
Options on fixed income always have a strike price, an expiration date and an underlying value. We will explain what these are:
Strike price
Also known as the exercise price, the strike price of a fixed income option is the price that is taken to compare the settlement price with, in order to calculate the value of the option and the settlement the investor will receive.
Expiration date
Derivatives such as fixed income options have an expiration date. This is the last day that the option contract is trading on the exchange. The holder can choose to close the position or to let the contract expire. As fixed income options are physically settled, the investor receives or delivers the underlying fixed income future at expiry. At expiry, the issuing exchange determines whether there is a remaining value.
Underlying value
In finance, derivatives have an underlying value. This can be an index, (basket of) assets or even another derivative. For fixed income options, fixed income futures serve as the underlying value.
Fixed income futures
Fixed income options are physically settled, which means that the investor receives or delivers the underlying fixed income future at expiry. Therefore, when exercising your long position, you will receive the underlying future. On the other hand, when exercising your short position, you have to provide the underlying futures.
Like options, futures derive their value from an underlying product. For fixed income futures, the underlying is typically a bond. But the chain does not stop here. Bond prices and interest rates have an inverse relationship. This means that when bond prices increase, interest rates decrease and vice versa. Therefore, investors can choose a long position in a fixed income option when expecting a decrease in the interest rate. A decreasing interest rate will, in this case, mean that the option price increases due to this inverse relationship. OGBL is an example of an option series for fixed income options. The underlying is the Bund future. Also, this future has an underlying product. In this case, those are German government bonds.
How can fixed income options be profitable?
With a short position in a fixed income option, the maximum profit is the premium received when entering the position. With a long position in a fixed income call option, the maximum profit is unlimited since the price of a bond can theoretically rise without a limit.
When an option has an intrinsic value, that option is "in the money". This is possible for both call options and put options. For example, call options are in the money when the exercise price is lower than the price of the underlying asset. A put option is in the money when the exercise price is higher than the underlying value. If the opposite is true, the option is "out of the money".
If you have a long position in a fixed income call option that is out of the money at expiry, then the option will expire worthless. All positions that are out of the money expire worthless at expiration, meaning that you can lose your entire investment with a long position in an option, namely the premium you paid when buying the option.
What are the risks of investing in fixed income options?
Investing in fixed income options can be beneficial, but it is not without risk. At DEGIRO, we are open and transparent about the risks associated with investing.
It is recommended that you read the Key Information Document (KID) thoroughly to ensure you understand the product you are investing in. This three-page document will provide key information on the specific option to investors, such as the costs and risks involved, and the investment objectives. It will not state what profits (or losses) can be expected from the investment. Information about contract specifications can usually be found on the website of the exchange where the option is listed.
Before you start investing, there are a number of factors important to consider. It helps to determine how much risk you are willing to take on and which products are best for you. In addition, it is not advisable to invest money that you may need in the short term or to take positions that may cause financial difficulties.
The information in this article is not written for advisory purposes, nor does it intend to recommend any investments. Investing involves risks. You can lose (a part of) your deposit. We advise you to only invest in financial products that match your knowledge and experience.
