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Thinking about your family’s financial security? Life insurance could help put a plan in place for the unexpected and cover a myriad of expenses.
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Cost of Carry, Explained and Defined
What Is Cost of Carry?
Cost of carry refers to any and all ongoing costs that you need to pay in conjunction with holding a given investment. Transaction costs, which are incurred upon the purchase or sale of the asset, are typically not considered a carrying cost.
Cost of carry can come in a variety of different forms — here are a few types of carrying costs that you’ll want to be aware of:
• Storage costs, if you are investing in the futures market for physical goods
• Interest paid on loans used for an investment
• Interest in margin accounts when borrowing to invest in stocks or options
• Costs to insure or transport physical goods
• The opportunity cost of investments
Most if not all investments have carrying costs, and savvy investors will take them into account when deciding whether an investment is worth it. Even if a particular investment doesn’t have obvious carrying costs, there is always the opportunity cost of making one investment over the other.
How Cost of Carry Works
The way that cost of carry works depends on the type of investment that you are considering. If you are investing in the futures markets for tangible goods like coffee, oil, gold, or wheat, you may have carrying costs associated with these physical goods. For example, if you buy a commodity like crude oil, you must pay the costs for transporting, insuring and storing that oil until you sell it.
To accurately calculate your trading profits you must include those carrying costs.
In a purely financial transaction like buying stock or trading options, there can still be carrying costs involved. You may have to pay interest if you are borrowing money with a margin account. You may also incur what are called opportunity costs. Opportunity costs refer to the money you could have made if you had invested your money in other areas.
If you are holding $10,000 in your stock account waiting for an option assignment, you can’t use that $10,000 for other investments.
Which Markets Are Impacted by Cost of Carry?
Cost of carry is a factor in a variety of different types of investments. Options trading has carrying costs from interest costs if you trade in a margin account to holding costs.
Investing in commodities may require a cost of storing, insuring, or transporting your goods. You should be aware that most types of investments also have opportunity costs.
Cost-of-Carry Calculation
The simplest cost-of-carry calculation just includes all of your carrying costs as a factor when you analyze the profitability of a particular investment. So, if
• P = Purchase price of an investment
• S = Sale price of the same investment
• C = carrying costs while holding the investment
The profit of this investment could be expressed as Profit = S – P – C.
Futures Cost of Carry
The futures market has two different prices for each type of commodity. The spot price refers to the price for immediate delivery (i.e. on the spot). A futures price is the price for goods at some specified time in the future. Because most futures contracts of commodities come with non-zero carrying costs, the futures price is usually (but not always) higher than the spot price.
Options Cost of Carry
When trading options the costs of carry fall into a few categories:
• Interest costs – Some investors borrow money to purchase options, i.e. a loan from a friend, a bank loan, or a brokerage margin account.
Whatever the source of the money, the interest paid to service the borrowing is a carrying cost.
• Opportunity costs – You’ve chosen to invest in options. But where else could you have invested that money? Because most alternative investments carry risk, as does investing in options, it’s difficult to make an apples-to-apples comparison.
In finance, we look at risk-free investing rates to assess the opportunity cost. “Risk-free” is defined as the return available by investing in U.S. Treasuries. In the past, 30-year bonds were the standard, but 10-year returns and even the return on short-term Treasury notes may also be used.
• Forgoing Dividends – One of the disadvantages of owning options compared to owning stock, is that you are not eligible for dividends as an option holder. The market makes an effort to price dividends into the option premium, but just as interest rates can fluctuate, so can dividend rates.
Examples of Cost of Carry
Here is a simple example of cost of carry and how it might affect an investment in purchasing Brent Crude Oil.
Say you buy a contract for 1,000 barrels of Brent Crude at $80/barrel. Six months later, the price of oil has gone up to $90/barrel, and you sell. You might think that you have earned a $10,000 profit, but that is not accounting for the cost of carrying the oil.
If it cost you $3,000 to store and insure those barrels of oil for the six months that you owned them, those carrying costs must be subtracted from your profit. You also are liable for delivering the oil, which might cost another $1,000. Considering the cost to carry, your actual profit was only $6,000. While these costs are easiest to understand with physical goods like commodities, most types of investments have carrying costs.
Cash and Carry Arbitrage
Like crypto arbitrage, there sometimes exists a type of arbitrage called cash-and-carry arbitrage. In cash-and-carry arbitrage, an investor will purchase a position in a stock or commodity and simultaneously sell a futures contract for the same stock or commodity.
If the futures price is higher than the combined amount of the stock price plus carrying costs, you can secure a relatively risk-free profit via cash and carry arbitrage.
Cost of Carry and Net Return
As we’ve discussed already, the cost of carry can have an impact on the net return of any investment. When determining your total profit and the return on investment (ROI), you need to account for any and all costs that you incur as part of the investment.
These might include transaction costs like commissions as well as carrying costs. Subtract all such costs from your gross profit to calculate the net return of your investment.
Can You Do Anything About Cost of Carry?
Since the cost of carry directly and negatively affects your total profit, you may be wondering if you can do anything about it. While there are carrying costs with almost every type of investment, one way to minimize the cost of carry is to avoid investments that have significant carrying costs.
On the other hand, if your specific situation allows you to have below market carrying costs, you may be able to earn a profit with cash and carry arbitrage.
The Takeaway
The cost of carry is a term used in options and futures trading that refers to the ongoing costs incurred in an investment while you are holding it.
With physical commodities, the cost of carry refers to storage, insurance, delivery and other costs specific to the fulfillment of your contract.
When applied to options trading the carrying costs are financial in nature, such as, interest costs, opportunity costs, and forgoing dividends.
If you’re ready to try your hand at options trading, you can set up an Active Invest brokerage account and trade trade options from the SoFi mobile app or through the web platform.
And if you have any questions, SoFi offers educational resources about options to learn more. SoFi doesn’t charge commissions, and members have access to complimentary financial advice from a professional.
FAQ
How can you calculate cost of carry?
The cost of carry refers to any costs that you incur during the course of your investment. In commodities trading, this generally refers to costs like storage, insurance, or delivery of the commodity. In other types of investments, the cost of carry could include interest charges or the opportunity cost of using your money.
Do bonds have a cost of carry?
Yes, nearly all investments, including bonds, have some sort of cost of carry. In the bond market, the cost of carry generally refers to the difference between the face value of the bond plus premiums minus applicable discounts.
How are ordering and carrying costs different?
Ordering costs are the costs that you pay as part of the ordering process. In a stock or option transaction, any broker’s commissions that you pay would be considered ordering costs. While ordering costs are usually incurred only once (at buy and/or sale), carrying costs are the costs that you must pay to hold an investment throughout its duration.
Photo credit: iStock/fizkes
SoFi Invest®
INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below:
Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.
Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
SOIN0322025
May
22
2023
Interest Rate Options, Explained
What Are Interest Rate Options?
Interest rate options enable investors to hedge, speculate on, or otherwise manage their exposure to interest rates. These financial derivatives are available as both puts and calls, and traded on major options exchanges.
Interest rates in the U.S. fluctuate continuously, with the Federal Reserve being a key driver, but not the only one. To mitigate these fluctuations, and also to profit from them, professional money managers turn to interest rates options as a source for risk management.
Interest rate options are sold on major options exchanges as standardized puts and calls, as the two main types of contracts are called in options terminology. Similar to puts and calls on equity securities, interest rate options represent directional bets on the value of an underlying asset.
The value of interest rate options is tied to yields on interest-rate-linked assets, typically Eurodollars and U.S. Treasuries of various maturities.
Buyers of interest rate options can buy exposure to various portions of the yield curve, for example, the 2-year, 5-year, and 10-year treasuries are standardized terms commonly sold on the CME Group exchanges. Professional money managers may use puts or calls at any given maturity to express their views on the future direction and volatility of interest rates.
How Interest Rate Options Work
Interest rate options afford the buyer the right to receive payment based on the spread between the yield of the underlying security on the expiration date and the original strike rate of the option, net of fees.
Interest rate options in the United States feature “European style” options exercise terms, which means they can only be exercised on the expiration date.
This contrasts with equity options, which more often contain “American style” exercise terms. This means they can be exercised at any time before they expire.
Buyers of interest rate options pay a “premium” per the terms of the options contract, which is the price paid by the buyer. Options pricing can be complex, to say the least, and to profit on a trade the buyer of the option will need interest rates to move in their favor enough to cover the cost of the option’s premium before they can profit.
In the event that interest rates don’t move in the option holder’s favor enough to overcome the strike rate, the option will expire worthless and the option holder incurs the total loss of their premium.
We’ll cover how this dynamic plays out with respect to both interest rate calls and puts.
How Do Interest Rate Call Options Work
Buyers of interest rate call options seek to benefit from rising interest rates. Should the yield on the underlying security close above its strike rate on the expiration date, the owner of an interest rate call option will receive a cash payout. This payout will be the difference between the option value at maturity and its strike.
Note that interest options are cash-settled. Unlike equity options, no exercise is required. If the rate is higher than the strike rate, the holder is paid the difference.
Interest rate call options, much like equity call options, give the buyer unlimited upside exposure to rising yields.
Holders of interest rate call options bear the risk that the option might expire out-of-the-money should interest rates remain beneath the strike by the expiration date. In this case, the maximum loss the owner of an interest rate call option can expect is limited to the premium paid.
How Do Interest Rate Put Options Work
In contrast, buyers of interest rate put options seek to benefit from falling interest rates. Interest rate puts give the put holder the right to receive payment based on the difference between the strike rate and the yield on the underlying security at expiration.
In this case, the strike rate is typically the maximum possible gain that a put holder may receive.
Holders of interest rate put options bear the risk that the option might expire worthless (out-of-the-money) if interest rates rise above the strike by the expiration date. In this case, the maximum loss the owner of an interest rate put option will incur is limited to the premium paid.
What Are the Risks of Trading Interest Rate Options?
Trading interest rate options involves enormous risk for any trader who either, 1) doesn’t understand the basic drivers of options valuation and interest rates, or 2) doesn’t understand how to structure their options trade properly to cap risk exposure. The corresponding leverage on options trades can result in enormous losses if improperly managed.
Traders will need to manage a number of key risks, and they may want to consider different strategies for trading options, when it comes to buying interest rate puts and calls. This includes “market risk,” which is the risk of price movements caused by any macroeconomic factor that affects the financial markets. It also includes “interest rate risk,” which is the risk that changes in interest rates might erode the value of one’s holdings.
Finally, user-friendly options trading is here.*
Trade options with SoFi Invest on an easy-to-use, intuitively designed online platform.
*Check out the OCC Options Disclosure Document.
Interest Rate Option Example
As an example, an investor seeking to hedge (or protect) their portfolio against rising interest rates can choose to buy an interest rate call option on a 10-year Treasury bond, expiring in 2 months at a strike of $50.00.
Strikes on interest rate options are a pseudo-conversion where the interest rate is multiplied by 10x and denominated in dollars. Therefore a 5.0% rate converts to a strike price of $50.
If the option’s premium is quoted at $0.50, then buying a single interest rate call option would cost you a $50 total premium, as each interest rate option affords you exposure to 100 shares of the underlying.
If yields rise for the next 2 months until the option expires, the underlying might be worth $55 by the time it’s exercised.
In this instance, you can calculate your net profit using the following equation:
(Underlying rate at expiry – Strike Price) X 100 – Contract Premium = Profit
($55 – $50) X 100 ) – $50 = Profit
$5 X 100 – $50 = Profit
$500 – $50 = $450 net profit
Remember that each option contract grants exposure to 100 units of the underlying, while options premiums are quoted for a single unit of the underlying. Remember also to use the actual total contract premium paid, as well as introduce a multiplier of 100, when calculating your net profit.
The Takeaway
Interest rate options can be of interest to investors who understand the underlying drivers of these securities. They essentially provide direct exposure to interest rates, on a leveraged basis, at a relatively competitive cost.
When employed strategically, interest rate options enable investors to enhance their upside or mitigate their downside in a volatile rate environment.
If you’re ready to try your hand at options trading, You can set up an Active Invest account and trade options online from the SoFi mobile app or through the web platform.
And if you have any questions, SoFi offers educational resources about options to learn more. SoFi doesn’t charge commissions, and members have access to complimentary financial advice from a professional.
FAQ
What are interest rate future options?
Interest rate future options are futures contracts which derive their value from an underlying interest-bearing security. The buyer of an interest rate futures option (the “long position”) purchases the right to receive the interest rate payment in the contract, while the seller (the “short position”) is obligated to pay the interest rate on the underlying contract.
In either case, interest rate future options enable both buyer and seller to lock in the price on an interest-bearing security, for future delivery, which offers both parties some level of price certainty.
What is an interest rate swaption?
Interest rate swaptions represent the right, but not the obligation, to enter an interest rate swap agreement on an agreed-upon date.
In exchange for the contract premium, the buyer of an interest rate swaption can choose whether they want to be a fixed-rate payer (“payer swaption”), or fixed-rate receiver (“receiver swaption”) on the underlying swap, with the counterparty taking the variable rate side of the transaction.
Unlike standard interest rate options, swaptions are over-the-counter products, which means they allow for more customized terms, so there’s more variety when it comes to expiration, the style of options exercise, and the exact notional amount.
What is interest rate risk?
Interest rate risk is the exposure of an investment to fluctuating interest rates in the open market. Interest rates can change on a daily basis according to any number of market influences, including investor expectations, actions, or even statements made by central banks.
If interest rates rise on any given day, that shift will typically erode the value of bonds and most-other fixed income securities. Conversely, if interest rates were to fall, the market value of outstanding fixed-income securities will typically increase instead. Interest rate risk represents your investment exposure to these fluctuations in rates.
Photo credit: iStock/LaylaBird
SoFi Invest®
INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below:
Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.
Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
SOIN0522014
May
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2023
May
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2023
What Is Universal Life Insurance?
What is universal life insurance? Universal life insurance plans let policyholders receive the contracted coverage over their lifetime. Here’s more info.
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