If you want to invest in government debt, there are two main ways to do it. You can either buy cash bonds or U.S. Treasuries, or you can trade derivatives on the debt such as options and futures. Derivatives such as debt options are particularly useful for hedging, and they are desirable to speculators wishing to cash in on interest rate fluctuations.
Within the debt options category, you can trade options on cash bonds or options on Treasury futures. For most people options on futures is a superior choice because of their high liquidity. The market for cash bond options is extremely limited and most trading is OTC and geared toward institutional clients.
Options on futures are structured like other options contracts—the owner has the right, but not the obligation, to buy or sell the futures contracts for a particular price on a particular date. The options buyer’s risk is limited to the cost of the premium, while the potential profit is virtually limitless. On the other hand, the seller’s profit is capped at the cost of the premium, and his losses are potentially unlimited.
Writing a covered option is a way to mitigate the seller’s risk. A covered option is one in which the seller either owns the underlying asset or has an opposite position on the asset in question. For example, if a trader writes an options contract on two-year Treasury futures and at the same time holds a long position in the same two-year T-note, the option would be considered covered. The seller’s potential loss is offset by his call option. An uncovered option is called a naked option; it is inherently far riskier than a covered one.
Options on Treasury futures are an excellent hedging tool, especially in an environment of interest rate volatility. Remember, when interest rates rise, bond prices fall, and when they fall, bond prices increase. If you have a long position in T-notes and you expect interest rates to climb, you would write put options on futures contracts. In this way, you reach risk parity and manage your interest rate risk.