Bonds have been taking a wild ride lately. Over the past four months, inflation fears sent long-term prices plunging, knocking $100 off the face value of a $1,000 bond. For folks willing to take a risk, those volatile price movements add up to opportunity. Using options, even small-time investors can place big bets on the direction of interest rates.
To be sure, it's a swim in shark-infested waters. Professional traders and big institutions, such as banks, dominate the actively traded interest-rate markets at the Chicago Board of Trade and the Chicago Mercantile Exchange. And First Lady Hillary Rodham Clinton's trading record notwithstanding, most of the individual investors who dabble in derivatives lose money. "It's not for the faint of heart. We're talking about a market with some pretty big spikes," notes Thomas A. Tyler Jr., a Chicago commodity-market consultant.
PLEASANT DREAMS. For small-time options traders, the best path is to buy and not sell contracts, so your losses are limited to the "premium," or price, of the contract. Small-time speculators favor straightforward purchases of either a single type of put, which confers the right to sell at a specific price in the future, or a single type of call, which confers the right to buy. Both hold out the chance of a quick jackpot, notes David A. Andalman, senior options analyst at Chicago's Alaron Trading Corp.: "The likelihood of the average Joe doubling his money is remote, but that's what people dream about."
It doesn't necessarily cost a lot to play. At the beginning of June, for instance, an investor betting that rates were going up could have purchased a U.S. Treasury bond put for a premium of $1,500 plus commission. That put gives the investor the option to sell a futures contract representing $100,000 in bonds at a price of 104, about where the market was trading. To overcome the premium, bond prices would have to decline--and fast. By Aug. 19, when the put expires, yields would have to rise from 7.3% to about 7.7%. If rates rose to 8%, the put would be worth about $3,100. If rates stay the same or decline by Aug. 19, however, it's like shooting snake eyes in Vegas--you lose.
For a speculator expecting rates to retreat from their present peaks, buying a call is the way to go. A September call option on 10-year Treasury-note futures at the Chicago Board of Trade also cost $1,500 as of early June. This time, the entire stake goes down the drain if rates stay the same or go higher. In fact, because of the premium, yields have to fall by nearly a half-percentage point by the option's Aug. 19 expiration before you would see any profits. But if the market moves your way, it's as much fun as hitting three cherries at the slots. If the yield on the 10-year note fell a full percentage point, to about 6.1%, the call would be worth some $6,000, quadrupling your money.
HEDGES. If you believe rates will move dramatically but aren't sure which way, you can make money by "spreads." An investor can buy a put and a call at identical prices for about $4,500. That is the maximum amount at risk. If yields move about a half-point up or down, the spread would be profitable.
Pros often use interest-rate options to hedge. An investor holding a portfolio of bonds can simply buy a put to offset losses caused by rising rates. Some small-fry investors are having some success with strategies that cover a small part of a portfolio's losses.
It may sound simple, but options are only for the valiant few. In Board of Trade interest-rate contracts, for instance, individual investors account for as little as 3% of the business. And of those, according to industry estimates, more than 80% lose money. One New Jersey-based user of interest-rate options suggests that anyone speculating as he does, "should have a conviction about where rates are going, and they should be prepared to lose all their money." Unless, that is, they happen to be right.
A MENU OF INTERST-RATE OPTIONS
U.S. TREASURY BOND Known for big price swings. Liquid even for small trades, it is popular among small investors. Traded on the Chicago Board of Trade (CBOT).
U.S TREASURY NOTE
Includes 10-, 5-, and 2-year maturities. Growing in popularity. 10-year volume soaring as government shifts debt financing to shorter-term instruments. CBOT.
LIBOR Based on London Interbank rate, 30-day maturities. Retail interest rare, though spread trades attract some small-time traders. Traded on the Chicago Mercantile Exchange.
U.S. TREASURY RATES Thinly traded. Prices are based on yields. Market-maker system guarantees minimum bid-ask spread. Chicago Board Options Exchange.