4 Things to Know About Interest Rate Options

Interest rate options are trade-able instruments like any other option. In specific, the buyers and sellers of these options are betting on the rise or fall of a particular interest rate. In the United States, the rate is usually the Treasury Bond rate or the eurodollar interest rate. If you feel you can interpret the movement of this interest rates in either the short or long-run, you could make a profit by putting your money on the table with your bet. Take a few factors into account first.

#1 Interest Rate Options are Derivatives

If you are an investor scared off by the word "derivative," then interest rate options are not for you. With this option purchase, you are not holding any underlying securities. You are simply betting on the movement of certain securities at some point in the future. Therefore, you are not increasing the value of your portfolio by purchasing these instruments. In fact, if you purchase on margin, or with a loan, you will be decreasing your portfolio's value. This can be very uncomfortable for many investors. 

#2 Interest Rate Options are Volatile

Investors purchasing options of any type are not seeking security. Options are risky bets, and you can lose money if your bet goes the wrong way. In fact, the only reason your option exists is because another investor is betting in the opposite direction. If you are building a low-risk portfolio, interest rate options are not the place to go. However, if you are looking to get a little more creative, interest rate options may be a good place to get familiar with derivatives and options. Since you are betting mostly on Treasury Bond rates, you are betting on a less volatile underlying security than many option models.

#3 You can Choose Between Exchange Traded vs. Over-the-Counter Options

An exchange traded interest rate option can be purchased on a stock exchange. Many interest rate options will trade this way. There are many that will exclusively trade over-the-counter (OTC), though. This means you are purchasing the option directly from a third party. This choice is often less familiar than going through an exchange, but it is also often met with lower transaction fees. Ultimately, the choice is yours as to where to purchase your options. However, note the differences between exchange and OTC options with your broker.

#4 Interest Rate Options may not be Permitted in Certain Portfolios

If you are looking to purchase securities for your IRA or similar qualified-plan portfolio, you will need to think twice about interest rate options. In most retirement portfolios, you will be restricted from trading on margin and trading derivatives. Some plan providers may present you with derivative options, but this is a questionable issue for most IRA providers, and it should generally be avoided. Therefore, interest rate option trades cannot be executed with tax-deferred funds in a retirement account. This extends to most qualified-plans. Check with your plan provider to learn of any choices that may be available to you, but know this type of trading is often restricted.

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