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How Bond Options Can Cut Rate Risk

Bond yields are rising, which is good news for income-oriented investors who want to earn more. But it’s not so good for owners of older bonds who see prices drop. If only there were a way to insure against price declines or even better, profit when bond values go down.

There is, though the process can be pretty risky and challenging for small investors. You can bet on the options market, but with bonds instead of stocks.

“Professional investors and traders use options as a way to hedge their position,” says Kyle Kroeger, a professional trader and founder of the Millionaire Mob investing and travel blog. “This is the clear case during periods of uncertainty, which we are currently in for interest rates. For a cost, investors can lock in the interest rates on bonds by using options to mitigate any fluctuations in price. You can effectively have a near risk-free interest rate through this hedging mechanism.”

[Read: Bonds Investors Need to Know About Maturity.]

Many small investors know something about stock options, which allow traders to bet on future stock prices, or to insure against loss on a stock, exchange-traded fund or stock index. But it’s likely that fewer investors know they could buy and sell options on bonds, too.

Options trading is risky, and experts say it is best left to investors with plenty of time to recover from setbacks. That would seem to leave out many of the investors most likely to have large bond positions.

“Traders who have a long investing time horizon and are willing to take on more risk would probably be able to weather the risks of options trading more so than, say, a retiree with a short-term time horizon,” says Chris Larkin, senior vice president of trading at E-Trade in New York.

Still, options are an option, so it can pay to know how they work.

Larkin notes a couple of bets investors with a taste for risk might make in today’s market:

“Traders who are bearish on rates and think the Fed will deviate from its course may choose to buy a call option on a bond ETF with a maturity around the Fed rate decision time frame,” he says. “If the Fed doesn’t raise rates or lowers them, the ETF’s value would rise and the trader would profit.

“On the other hand, traders who are bullish on rates and think the Fed will continue to raise them, may choose to buy put options.”

If that sounds like Greek, it could pay to bone up.

Like stock options, bond options give their owners the right to buy (call) or sell (put) a block of the underlying security at a set strike price on or before a given expiration date. If prices rise, the owner of a call can profit by “exercising” the option to buy at the low strike price and then selling at the higher spot price. A put lets its owner profit on a price drop by buying at the new low price and selling at the higher strike price. In either case the party on the other side of the deal loses — the call “writer” must sell at a below-market price, the put writer must buy at an above-market price.

The options market for stocks is huge and well known even among small investors who may not ever trade options themselves. But bond options don’t get as much attention. Pros use them, ordinary investors not so much.

[See: 7 Bond Funds to Buy as Rates Rise.]

Still, a bond option could come in handy in times like these. As interest rates rise, prices of older bonds fall, because investors shun older bonds that pay less than newer ones. For a long-term bond, a one percentage point rise in prevailing rates can easily cause a 10 percent drop in price. A bond option could offset that loss.

Trading options on bonds, or in many cases options on bond futures, requires opening an account with a brokerage adept at this kind of speculation, as the market for small investors is not as easy to enter as the market for stock options.

“When we think about options on bonds, what’s important to keep in mind is most are traded over the counter,” Larkin says, describing the marketplace for securities not traded on major exchanges.

It’s also easier to bet options on U.S Treasury bonds than corporate, municipal or foreign bonds. Bond options are usually used as a bet on the general direction of interest rates, not on credit quality or default risk.

The easiest way for a small investor to get into this market is to trade options on exchange-traded funds that own bonds. ETFs are traded like stocks, and some have deep options markets.

A fixed-income investor can trade options on ETFs that are similar to the bond stake, even if not identical. An investor who owns a bond ETF might write covered calls to boost income. The covered-call writer creates an option contract, taking on the obligation to sell the ETF shares at a set price if the contract owner opts to exercise. The writer earns a premium for selling the contract and keeps it regardless of whether the buyer exercises.

“Investors typically get fixed income exposure through an ETF, which would have a corresponding options contract available,” Larkin says. “What’s great is investors can use a similar strategy that they would to mitigate stock exposure. For example, if they are worried about rising rates, they can buy puts to protect their bond ETF position.” The put would rise in value if rising rates drove down bond prices.

While the basic principles of options trading are not hard to master, experts caution that options involving bonds involve issues that can trip up a trader.

Zero-sum game. All options — stocks or bonds — are a zero-sum game, with a loser for every winner. A small investor just getting into this would likely be up against traders with a lot more experience, better information and deeper pockets. Buying an option means paying a premium that varies with options terms and market conditions.

“Using options to hedge interest rate risk is effective, but only so on bond yields that offer attractive interest rates because sometimes the yield doesn’t cover the cost of the option,” Kroeger says.

Requires attention. Options contracts tend to lose value as the expiration date approaches and there is less time for the security price to move in the trader’s favor. For bond options there are additional factors like the approach of the bond’s maturity.

[Read: Which Treasury Bonds Are Best?]

A foreign language. Terms like call, put, premium and strike price are just the beginning. The options trader should also master a string of unfamiliar terms like beta, delta and gamma that describe factors affecting the option’s value.

The bottom line. Trading bond options is something the small investor can do to speculate on interest-rate changes, to insure a bond portfolio or to boost income. But it’s a risky, alien world that should best left to those who are willing to learn some tricky skills, work hard and live with some nasty losses in the early days.

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How Bond Options Can Cut Rate Risk originally appeared on usnews.com



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