Yield-Based Option

Yield-Based Option: Meaning, Types, Pros and Cons

What is a yield-based option?

A yield-based option (also called an interest-rate option) is a derivative that gives the buyer the right, but not the obligation, to buy or sell based on the yield of a security rather than its price. The option’s underlying value is equal to 10 times the yield (so a 1.6% yield → underlying value 16). These options are cash-settled and are typically European-style (exercise only at expiration).

How they work

• Calls on yields profit when yields rise; puts profit when yields fall.
• The option is “in the money” when the actual yield (expressed via the 10× convention) is above the strike for a call or below the strike for a put.
• Settlement is in cash: the option writer pays the difference between the actual underlying value (10× yield) and the strike at expiration.
• Premiums move with expectations: rising yields tend to raise call premiums and lower put premiums.
• Time decay applies—if yields do not move as anticipated before expiration, the buyer can lose the premium paid.

Example:
* Underlying yield = 1.6% → underlying value = 16.
* Strike = 14. If the underlying at expiration is 16, a yield-based call would settle for the difference (16 − 14 = 2), paid in cash.

Common types / underlyings

Yield-based options are often written on Treasury yields:
* 13-week T‑bill yields (IRX) — most sensitive to short-term rate changes.
* 5-year Treasury yields (FVX)
* 10-year Treasury yields (TNX)
* 30-year Treasury yields (TYX) — longer maturities are generally less responsive to short-term moves.

Benefits

• Direct way to hedge interest-rate exposure or to profit from rising rates.
• One of the few instruments that can gain value when interest rates rise.
• Useful when central banks pursue sustained rate hikes that depress risk-asset prices.

Drawbacks and alternatives

• Less familiar to many investors than options on ETFs or other standard derivatives.
• Suffer from time decay; prolonged rate stability can erode option value.
• Complexity and liquidity can be issues compared with ETF-based strategies.
• Alternatives: buying puts on long-term Treasury ETFs or using options on interest-rate-sensitive ETFs can provide some similar exposure with easier accessibility.

Key takeaways

• Yield-based options let traders take positions directly on interest-rate movements by using a 10× yield convention as the underlying.
• They are cash-settled European options useful for hedging against or speculating on changes in interest rates.
• While powerful in rising-rate environments, they carry time decay and complexity; ETF-based approaches can be simpler alternatives for many investors.