How Options Trading Works

Options are contracts that give their holders the right, but not the obligation, to buy or sell a given commodity at a set price within a certain period. In the case of Security Pacific’s options-trading program, the underlying commodities will be U.S. government securities such as Treasury bills and Treasury bonds.

Because the option holder faces only the risk of losing his or her “premium”--the price paid to acquire the option--purchasing an option is a low-risk way of hedging risks in the broader market. However, at the other end of the trades are speculators who could lose far more than their initial investments.

For example, the owner of $1 million in Treasury bonds priced at 95 ($95 for each $100 of face value) might want to hedge against the risk that interest rates will rise in the next three months, driving the bonds’ price down. He could do this by purchasing a “put” option giving him the right, but not the obligation, to sell the bonds at 95. If the bonds fall to 90, he can exercise the option. (The seller, or issuer, of the option faces the corresponding risk that he will be forced to buy at 95 bonds that he can resell at only 90.)

If interest rates fall and the bond price rises above 95, the option holder simply allows the option to expire, having lost only the premium. In this case, the option issuer has made his money by pocketing the premium.

As interest rates have turned more volatile during the past several years and the inflow of foreign capital has made the market in U.S. government securities more active, investors in these markets have sought a broader range of hedging instruments.

The Chicago Board of Trade’s futures market on T-bonds is the busiest commodity market in the world, far outstripping the trading volume of such traditional commodities as grain; its market in options on that future is the world’s third-largest.

The participants in these markets are almost exclusively professional investors. They include the 36 primary dealers in Treasury securities--those firms with permission to trade such securities directly with the U.S. government--as well as large-scale investment managers whose portfolio values are linked to interest rates and investment houses holding a large inventory of bonds and other fixed-income securities.