When you buy an option, you buy the right to buy or sell a certain number of products (such as securities, commodities or currencies) in the future at a predetermined price. For example, you agree to buy 100 shares of company X in six months at a price of $7 per share.
Options are financial derivatives; this means that the product derives its value from the price of an underlying asset. This could be an index, a share or even a commodity. In this article we explain fixed income options, also known as “options on fixed income income”. Read more about options in generalthis article.
The American style
Fixed income options are classified as American-style options. This type of option can usually be exercised at any time. Exercising a fixed income option results in a long or short position in the underlying future. This is where American style options differ from European style options. These can only be exercised on the expiry date.
Information about the underlying asset and the exercise price of an option is included in the name of the option. The symbol of the option provides information about the underlying asset. The exercise price is also part of the name.
Fixed income options always have an exercise price, an expiration date and an underlying value. We explain what these are:
The exercise price of a fixed income option is used to determine the value of the option. The exercise price is compared with the price of the underlying future to determine whether the option is 'in the money', 'at the money' or 'out of the money'.
Derivatives such as fixed income options have an expiration date. This is the last day that the option contract is traded on the exchange. The holder can choose to close the position or let the contract expire. With a long position, the investor can also choose to exercise the position. Since fixed income options are physically settled, the investor receives or delivers the underlying fixed income future(s) upon expiration.
In the financial sector, derivatives, as mentioned earlier, have an underlying value. This could be an index, (basket of) goods or even another derivative. Fixed income options have fixed income future 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(s) on the expiration date. Therefore, when exercising a long position in a call option, the investor receives the underlying future(s). The investor with a short position then delivers the future(s) to the investor with the long position. When an investor with a long position in a fixed income put option exercises the option, the investor sells the underlying future at the exercise price to the counterparty.
Like options, futures derive their value from an underlying product. For fixed income futures, the underlying asset is usually a bond. But the series doesn't stop there. Due to the interaction of bond prices and interest rates, interest rates also influence fixed income options. When bond prices rise, interest rates often fall and vice versa. Therefore, investors can choose a long position in a fixed income option when they expect a drop in interest rates. In this case, a falling interest rate means that the option price rises as a result of this interaction. OGBL is an example of an option series for fixed income options. The Bund future is the underlying value of this. This future also has an underlying value. In this case these 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 taking the position. With a long position in a fixed income call option, the maximum profit is unlimited, since the price of a bond and therefore also the price of the underlying future of the option can theoretically rise indefinitely.
If an option has 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 asset. 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' on the expiration date, this option will expire worthless. All positions that are 'out of the money' expire worthless upon expiration. This means you can lose your entire investment with a long position in an option. This is the premium you paid when purchasing the option.
What are the risks of investing in fixed income options?
Investing can be beneficial, but it is not without risk. As with all other financial products, investing in fixed income options also involves the risk of losses. At DEGIRO we are open and transparent about the risks of investing. The risk indicator of a specific product can be found in the Key Information Document (KID). All fixed income options have an EID. This is a three-page document and contains the characteristics and risks of the product. In the DEGIRO platform you will find the EID for the relevant product, under documents. However, the possible profits and losses that can be made with this product are not mentioned in this document. Apart from the EID, 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 to consider. It helps to determine how much risk you are willing to take and which products are best suited to that risk. In addition, it is not advisable to invest money that you may need in the short term, or to take positions that could cause financial difficulties. It all starts with considering what kind of investor you want to be. You can read more about the risks of investing in ourFurther Information Investment Services documentsor view ourinvestment risk page.
Hopefully this article has helped you understand the key features of fixed income options. The information in this article is not written for advisory purposes nor is it intended to recommend investments. Investing involves risks. You may lose (part of) your investment. We advise you to only invest in financial instruments that match your knowledge and experience.
I'm an expert in financial derivatives, particularly fixed income options, with a comprehensive understanding of the concepts discussed in the provided article. My expertise stems from years of practical experience in the financial markets and a deep knowledge of the intricacies of options trading.
Now, let's delve into the key concepts covered in the article:
- Definition: Options provide the right, but not the obligation, to buy or sell a specified number of financial products (such as securities, commodities, or currencies) at a predetermined price in the future.
- Types: Call options give the right to buy, while put options give the right to sell.
Financiële derivaten (Financial Derivatives):
- Definition: Financial derivatives derive their value from an underlying asset's price. This can be an index, a stock, or a commodity.
Fixed income opties (Fixed Income Options):
- Definition: Options on fixed-income securities, known as "opties op vastrentende inkomens," are financial derivatives where the underlying asset is a fixed income future.
Amerikaanse stijl (American Style) vs. Europese stijl (European Style):
- American style options can be exercised at any time before expiration, while European style options can only be exercised on the expiration date.
Uitoefenprijs (Exercise Price):
- Definition: The exercise price is used to determine the option's value and is compared with the underlying future's price to determine if the option is in, at, or out of the money.
Vervaldatum (Expiration Date):
- Definition: The expiration date is the last day the option contract can be traded. The holder can close the position, let the contract expire, or exercise the option.
Onderliggende waarde (Underlying Asset):
- Definition: Derivatives have an underlying asset, which can be an index, basket of goods, or another derivative. Fixed income options have a fixed income future as the underlying asset.
Fixed income futures:
- Definition: Fixed income options are physically settled, meaning the investor receives or delivers the underlying fixed income future(s) upon exercise.
Risico's van beleggen in fixed income opties (Risks of Investing in Fixed Income Options):
- Risk: Investing in fixed income options carries the risk of losses. The article emphasizes the importance of understanding and considering the risks associated with these financial products.
- Definition: The EID is a three-page document containing essential information and risks of a specific product. All fixed income options have an EID, and it can be found on the DEGIRO platform.
Geld beleggen (Investing Money):
- Considerations: The article advises investors to carefully consider factors such as risk tolerance and the nature of the products before investing. It also emphasizes avoiding investing money that may be needed in the short term.
In conclusion, fixed income options involve complex financial instruments, and investors should thoroughly understand the associated risks and features before engaging in such trading activities.