The Chicago Board Options Exchange (CBOE) offers interest rate option trading. CBOE describes interest rate options as “European-style, cash-settled options on the yield of U.S. Treasury securities.” This is one of the kinds of options trading that deals solely in projected interest rates. These options trade in U.S. Treasury bills with short, medium, and long term rates. Options trading terms are the same in trading interest rates as in other options trading.

Interest rate option trading is referred to as trading in yield based options. In trading interest rates on U.S. Treasury bills the individual who buys a call option expects the prevailing interest rate to go up. The individual who buys a put expects the rate to go down. For the buyer of a call option to profit, the underlying interest rate must rise above the strike price by more than the premium paid. For the buyer of a put option to profit, the interest rate must drop below the strike price by at least the price of the premium. In addition, taxes and commissions will figure into the cost analysis for interest rate option trading. For using risk management in options trading the same types of combinations of puts and calls, buys and sells apply as throughout options trading.

Interest rate option trading products offered by CBOE include the thirteen week Treasury bill which trades under the symbol IRX, the five and ten year notes as FVX and TNX, and the thirty year bond as TYX. Strike prices and spot prices in options trading work the same on interest rates as in other options. The buyer profits when the spot price rises or falls from the strike price, depending upon whether he or she purchased a call or a put. The seller is betting that the spot price will not move significantly away from the strike price so that he or she will gain the premium paid for the option and will not lose on a large adverse movement in the interest rate of the  product involved.

Options expiration dates for interest rate option trading at CBOE are the Saturday following the third Friday of the expiration month. The option value of interest rate options is ten times the yield of the underlying security. For example an interest rate of 3% on a 5 year bond makes the option worth $30. Interest rate options trading contracts are settled in cash. There is no need to buy or sell the actual bills, notes, or bonds. Contracts are multiples of 100. In the matter of United States versus other options trading interest rate option trading is done in European style. Thus all contracts are settled on expiration, never before. While the multiplier for contract is 100 the strike price intervals are quoted at every two and a half points as opposed to every five points on a standard strike table. A one point interval is 10 basis points. Premiums are quoted as one point for every $100 and are in decimals.

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In determining option value of a call option on 100 shares of stock we know the strike price, which is the price of the security when the option is written and the price of the underlying stock if the option is exercised. We also know the current market price of the stock. If the security has gone up in price, part of the option’s value will be the current market price minus the strike price for the block of stocks.

If you borrowed money to buy the option or simply took money from your bank account there is a cost to holding the position. The cost of holding the option position should be subtracted from any option value gained from a stock price increase. This factor especially applies to holding on to an option instead of selling it. Another factor is if the stock pays dividends. The value of the option will include the value of the dividend on the block of stocks up until when the dividend is paid. Then the option value goes down by the value of the dividend.

Determining option value also includes the time remaining to expiration of the options contract. In the example of purchasing a call option you may be “in the money” in that the current stock price is above the strike price. If the underlying stock is slowly increasing in value it may be that letting the option contract ride a little longer will allow you to make more money when you exercise the option. This factor in determining option value leads to the next factor, predicting the future of the underlying stock.

Determining option value really hinges on this factor. Everything else can be calculated with addition and subtraction. Predicting the future relies on the probabilities that the stock’s price will either go up or down. This factor is what makes the purchase of call options potentially lucrative. One pays a small amount, a premium, to purchase the right to buy stock at a set price, the strike price, no matter how high the stock price may go.

If you believe that a stock will go up you can buy the stock, wait for the rise in stock value, and sell, pocketing your profit, minus commissions. If you choose to purchase an option on the same stock you risk losing your premium but can exercise the option to buy at the strike price while you simultaneously sell at the spot price or market price.

Thus, of the various factors, determining option value relies, potentially, most heavily on predicting how much the underlying stock will be up until expiration.

For someone buying a put to protect a stock position in a very volatile market the option value is its insurance value as the individual only intends to exercise the put option if the spot price drops below the strike price. Similarly for someone selling a call option the option value is the premium as the selling cannot profit from a divergence of the spot price from the strike price.

Option value is different for the buyer of a call option. Here the buyer stands to make a lot of money if the spot price goes far above the strike price. The option value will, in fact, go up as the spot price goes up. Thus the option becomes more expensive to buy. As options are traded during the term of their contract an options trader need never buy or sell stock, only trade the option. For the buyer of a call option the option value can be a multiple of the premium paid if the spot price rises substantially over the strike price. The only risk for the buyer of an option is that there is no option value if the spot price does not rise above the strike price.

Generally option value is based upon the following:

• The day’s market price of the security in question
• The strike price of the option (in relation to the spot price
• Costs and profits involved in holding a position in an underlying security
• Time to expiration of the options contract
• The market estimate of what the spot price will be at the end of the contract and how much the stock will fluctuate from now to then

The ideal situation when buying a call option is that the option value is low at the beginning of the contract and as the spot price fluctuates and, hopefully, goes up the option value goes up with the spot price. When the market decides that a stock’s spot price is likely to go up or down dramatically is when the option value moves (up or down) dramatically. This is one place where fortunes are made in options trading. An payment of a premium of two to four dollars a share for a 100 share block of stock can turn into tens of dollars a share if the spot price rises substantially above the strike price.

If you bought stock at $50 a share and the spot price goes to $100 a share you are a happy investor with a 100% profit to brag about at the office. If you paid $2 a share for a call option on the same stock you will make a 25 fold or 2500% profit. In that case the option value will be such that you may be sailing your yacht around the world and no longer in the office.

You can profit from options in two basic ways. You can sell call or put options and earn a premium which is what the buyer pays in order to have the option to buy (in the case of a call option) or sell (in the case of a put option). You can also buy call or put options and have the opportunity of earning the difference between the spot price and the strike price, minus the premium you paid to get that option.

In the case of selling call options you really do not want the market price or spot price to go up so that you can earn your premium and keep your stock. You risk in selling a call option is that the stock will double in value overnight and you will miss out. In the case of buying call options you want the stock to go up more than the premium you paid so that you can exercise you option and collect the difference between the strike price (exercise price) which is what you will pay and the spot price (market price) which is what the stock will now be worth. Remember, however, that the stock needs to go up more than the premium you paid and, if you are going to immediately sell the stock, more than the premium and the commissions you will pay.

If you are selling a put option then, as with selling a call option, you will earn a premium from the buyer. However, with a put option there is a potentially large risk. If the market price (the spot price) drops substantially below the strike price (exercise price) then the buyer will exercise the option and you will need to buy the stock at the now higher strike price or exercise price and either hold on to it or sell it for a loss at the now lower market price or spot price.

If you are buying a put option you pay the premium to protect your stock position at the strike price. If the stock goes well above the spot price (exercise price) you are happy and do not exercise the option. If the stock goes well below the spot price (exercise price) then you exercise the option and the seller of the put option buys your stock at the strike price (exercise price) instead of the, now, much lower spot price.

Assuming that you are learning the terminology, the strike price or exercise price is the price at which an options contract is exercised. The spot price is the market price when the term of the option contract expires.