RHO: Why Interest Rates Effect Our Option Premiums
Dr. Alan Ellman | Nov 16, 2014 02:17AM ET
Interest rates and the option Greeks play an important role in understanding option trading basics. Rho, not considered a major Greek, measures the change in an option’s price resulting from a 1% change in interest rates. When interest rates do change, it is normally by 25 basis points, not a full percentage point and that’s why option prices will not be heavily impacted in the short-term by interest rates.
However, as Blue Collar Investors, we need to be educated in all aspects of our investment strategies and interest rates do play a role. Let’s start with a basic premise:
When the interest rate rises by 1%, call value will increase by the amount of its rho and put value will decrease by the amount of its rho.
Here is an example from an options calculator (www.cboe.com) showing a positive rho for calls and a negative rho for puts as interest rates increase:
For the 21-day period until expiration, the interest rate is 0.1535 (left side), the cost to own the shares (if the money to purchase the shares are borrowed or the interest lost if not borrowed). Should interest rates increase by 1%, the call value will increase by 1.38 cents and the put value will decline by 1.35 cents from the current value of $1.70 (right side). Given that interest rates generally change by 25 basis points when there is an adjustment, the practical impact on our option premiums would be one fourth these amounts. We can now understand why rho is considered a minor Greek.
Why rising interest rates increase call value
There is an interest advantage to buying call options. Let’s assume for a moment that we are interested in a $60 stock and want to purchase 300 shares. The cost before commissions is $18,000. Now if a $30 call can be purchases at parity (intrinsic value only or $30- the amount the strike is in-the-money), the cost would be cut in half to $9,000. The risk is cut in half and the reward is nearly the same. Now the $9,000 not spent on buying the shares can be deposited into an interest-bearing account to generate income. The higher the interest rates, the more valuable call options become and so the rho impacts calls in a positive manner as interest rates rise.
Why rising interest rates decrease put value
There is an interest disadvantage to buying puts. There is a theoretical cost to buying puts, the interest cost to buy the options. We benefit when share price declines and put value then accelerates in much the way professional traders benefit from shorting stocks. When a stock is shorted, cash is generated into the brokerage account which will result in an interest credit (professional traders do pay some interest for borrowing shares that were shorted). The choice then becomes do these traders pay interest as puts are purchased or do they receive interest as shares are shorted? As interest rates increase, put-buying becomes less attractive and stock shorting becomes more attractive (mainly for professional traders who impact option value much more than we do).
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Summary
Rho is a minor Greek, impacting option premiums as interest rates change. Call and put premiums are impacted inversely as rates rise or fall. Understanding how and why interest rates effect option premiums make us all better investors.
Market tone
There were few economic reports this past week although there were some potentially positive economic news regarding changes in tariff requirements in China and India:
- According to the Commerce Department, retail sales increased by 0.3% in October compared to the 0.2% expected
- According to the Commerce Department, business inventories rose by 0.3% in September, better than the 0.2% anticipated
For the week, the S&P 500 edged up 0.4%, for a year-to-date return of 12%, including dividends.
Summary
IBD: Confirmed uptrend
GMI:6/6- Buy signal since market close of October 27, 2014
BCI: Moderately bullish favoring out-of-the-money strikes 2-to-1
Wishing you the best in investing,
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